NET WORTH OR ARBITRARY ASSESSMENTS - PART I

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1 NET WORTH OR ARBITRARY ASSESSMENTS - PART I This issue of the Legal Business Report provides current information to the clients of Alpert Law Firm on net worth assessments under the Income Tax Act (Canada) and the possible challenges to such assessments. Alpert Law Firm is experienced in providing legal services to its clients relating to challenges to net worth or arbitrary assessments. A. NET WORTH ASSESSMENTS Pursuant to the provisions of subsection 152(7) of the Income Tax Act (the "Act"), the Minister of National Revenue (the "Minister") may make what is known as a Net Worth Assessment (also known as an arbitrary assessment) as a method of estimating an individual's annual income where: (i) no tax return has been filed; (ii) the Minister considers that the tax return which has been filed is inaccurate; or (iii) the taxpayer has not maintained adequate records of the taxpayer's income. It is important to note that the Minister is not bound by the information contained in the return or the information supplied by the taxpayer. Specifically, the calculation of the net worth assessment consists of two steps: (i) in the first step there is a comparison of the taxpayer's net worth (i.e. the taxpayer's assets less liabilities) at the beginning of the taxation year, with the taxpayer's net worth at the end of the taxation year; (ii) and in the second step the taxpayer's estimated cost of living expenses for the taxation year are then added to the difference in net worth, which is so determined from the comparison above. The resulting figure is the net worth assessment for the taxpayer's income and, according to subsection 152(8) of the Act, is assumed to be the taxpayer's income unless the taxpayer establishes that there is an error, defect or omission in the assessment. The taxpayer is bound by the net worth assessment, unless the taxpayer files a notice of objection within 90 days from the date of mailing the assessment, as provided in section 165 of the Act. When calculating the cost of living expenses of the taxpayer the Minister can use the information provided by the taxpayer and/or information derived from the national averages provided in Statistics Canada ("StatsCan") expenditure figures. In general, the Courts have found that the net worth method of assessing is an unsatisfactory and imprecise method of determining a taxpayer's income and should only be used as a last resort when all else fails. Although the net worth assessment is viewed to be an imprecise method, the burden of proof is on the taxpayer to rebut the LEGAL BUSINESS REPORT / JUNE

2 assessment. If the taxpayer is unsuccessful in rebutting all or a part of the assessment, then the portion of the net worth assessment that was not successfully rebutted will stand, pursuant to subsection 152(8) of the Act. In addition, due to the nature of the allegations, penalties are often assessed against the taxpayer alleging that the taxpayer knowingly, or in circumstances amounting to gross negligence neglected to report income. Where penalties are assessed, the burden of proof is on the Minister to justify their imposition. In addition, it is also possible that the taxpayer could be charged criminally with income tax evasion pursuant to the provisions of subsection 239(1) of the Act. 1. Lacroix v. The Queen, 2009 DTC 5029 In this Federal Court of Appeal case, the taxpayer was asked by the Canada Revenue Agency to prepare balance sheets for each taxation year from 1995 to As the taxpayer s balance sheet reported a significant amount of liquid assets totaling $500,000 for the 1995 taxation year, the CRA conducted a net worth assessment, which revealed significant discrepancies between the taxpayer s reported income and the value of his actual assets. The Minister then reassessed the taxpayer for unreported income of around $145,000 for 1997, $231,000 for 1998, $156,000 for 1999 and $26,000 for 2000, which totalled $558,000 for all four years. The Minister also imposed gross negligence penalties against the taxpayer pursuant to subsection 163(2) of the Act. The taxpayer filed a Notice of Appeal for each of the relevant taxation years by claiming that the source of the $500,000 on his balance sheet was from a loan made to him by a creditor, whose son he had rescued from drowning. However, the Minister and the Tax Court of Canada rejected the taxpayer s explanation, as all that was presented to support the taxpayer s claim were the testimonies of the taxpayer and the creditor, both of whom lacked credibility. The taxpayer then appealed the Tax Court s decision to the Federal Court of Appeal. The Federal Court of Appeal dismissed the taxpayer s appeal, and held that the Minister is not required to show proof of the source of the taxpayer s unreported income when the taxpayer appeals the reassessment. The Minister need only set out the presumptions of fact used in the reassessment before the onus shifts to the taxpayer to demolish the Minister s assumptions. If the taxpayer is unable to meet the onus of demolishing the Minister s assumptions, the Minister s assumptions are then presumed to be true. It is only when a taxpayer presents credible evidence to support his appeal that the Minister must go beyond the assumptions of fact and file evidence to LEGAL BUSINESS REPORT / JUNE

3 prove the existence of the unreported income. In the case at hand, the Minister was correct to rely on the discrepancy between the taxpayer s reported income and his actual assets as a basis for the reassessments. Since the taxpayer was unable to provide a credible explanation to sufficiently challenge the accuracy of the assessments, the Minister s assumption that the taxpayer had underestimated his taxable income in the years 1997 to 2000 inclusive were presumed to be true. Although the Minister ordinarily has the advantage of assuming the facts that form the basis of a taxpayer s reassessment, the Minister does not enjoy the same privileges with regard to proving the facts justifying the assessment of a penalty against the taxpayer. The Court held that although the burden of proof is ordinarily on the Minister to prove the elements for a gross negligence penalty, the penalty in this case was justified because the taxpayer failed to provide a credible explanation for the unreported income. Since there was no viable and reasonable hypothesis that could have allowed the Tax Court to provide relief from the penalty assessment, the inevitable conclusion was that the false tax return was filed knowingly, or under circumstances that amounted to gross negligence. B. DEFENCES TO NET WORTH ASSESSMENTS There are various defences that a taxpayer can employ to successfully challenge all or a portion of the net worth assessment. (i) GIFTS AND INHERITANCES A net worth assessment can be challenged on the basis that the increase in net worth is attributed in whole or in part to receipt of gifts or inheritances, which are not taxable. A taxpayer can receive a gift or inheritance on a tax-free basis pursuant to the Act. In the absence of documentation that proves receipt of gifts, the Courts may give considerable weight to testimony provided by the taxpayer and witnesses who are able to offer corroboration, such as the donor, friends, relatives, and the donor s accountant. In general, the Courts will consider all reasonable explanations for the accumulation of wealth before giving considerable weight to the explanation of receipt of gifts. LEGAL BUSINESS REPORT / JUNE

4 1. Pasnak v. M.N.R., 84 DTC 1677 The Minister reassessed the taxpayer using the net worth assessment on the basis that the taxpayer had failed to report over $200,000 of income. The taxpayer, who was a cattle and grain farmer, appealed to the Tax Court of Canada contending that this increase in income was attributed to gifts he had received, and as such should not be included in the net worth assessment. The taxpayer argued that he received various monetary gifts from his father prior to his death and from his mother shortly following his father's death. In the absence of documentation that indicated that the source of additional assets were actually attributed to the receipt of gifts, the accountant of the taxpayer's father gave evidence that the taxpayer's father had the financial ability to actually give these gifts to his son. The Court gave considerable weight to the testimony of the accountant, deeming him to be a credible witness. The Court also gave weight to the fact that no other explanation was plausible given that such a large accumulation of wealth could not have come from the taxpayer's farming activity since his farming operations remained the same as in previous years in which there was no such additional assets. As such, the Court ordered that the income as estimated by the net worth assessment be reduced to reflect the gifts. In doing so the Court underscored that the receipt of gifts by a taxpayer is a possible challenge to net worth assessments. 2. Cheng v. The Queen, 97 DTC 286 In this case the taxpayer appealed the Minister's net worth assessment to the Tax Court of Canada on the basis that the assessment failed to take into account various gifts the he received from his mother, father and mother-in-law. The taxpayer owned a sporting goods company. He claimed that although the gifts were given to the company, it did not constitute business income and should not be taxed as such. While no written record was kept of all the monies received, the Court found that the taxpayer's oral testimony was credible enough to reduce the net worth assessment to take into account certain gifts from the taxpayer's relatives. Thus, the Court does not necessarily require documentation to find receipt of gifts as an explanation of the taxpayer's increase in net worth; oral testimony can be sufficient if it is found to be credible having regard to all of the facts and circumstances of the case. LEGAL BUSINESS REPORT / JUNE

5 3. Cox v. The Queen, 2002 DTC 1515 The taxpayer, who was represented by Alpert Law Firm, was assessed for a total of seven years. In three of these years, the taxpayer had amassed a substantial fortune in mutual funds, but had altogether failed to file tax returns. In the remaining four years, the taxpayer, upon request from the Minister, had filed tax returns that were prepared by "volunteers" for Revenue Canada. The Minister employed the net worth assessment method to discern the taxpayer's income for these seven years and used figures from StatsCan to estimate the taxpayer's cost of living expenses. The taxpayer appealed to the Tax Court of Canada challenging the Minister's net worth assessment and the penalties imposed. The taxpayer raised three main defences: (i) receipt of gifts and inheritances; (ii) challenging the estimation of cost of living expenses; and (iii) challenging the assessment of penalties on the basis of his mental condition. The taxpayer asserted that some of his assets were attributed to the gifts his girlfriend gave to him over the years in question. He claimed he received approximately $9,360 to $10,800 a year from his girlfriend. His girlfriend was also a schizophrenic, who, in addition to receiving a disability pension, received a monthly income of $700 to $1,200 from her wealthy family. There was no documentation to support the taxpayer's testimony about secondary gifts, however the taxpayer's brother corroborated the taxpayer's claim by testifying that the taxpayer received approximately $10,000 a year from his girlfriend. The Court accepted the verbal testimony, but opted for the lower amount of $7,000 a year for each of the seven years. As such, the net worth assessment was reduced by a total of $49,000 to take into account the monetary gifts the taxpayer received. The taxpayer also asserted that his increase in net worth was partly a result of being paid $21,600 for his share of an inheritance resulting from the sale of the family home. This claim was corroborated by the taxpayer's brother. The Court found this inheritance payment was a partial explanation for the increase in net worth, and reduced the net worth assessment accordingly. 4. Ba Phan v. The Queen, 2011 DTC 1290 In this case, the taxpayer had immigrated to Canada from Vietnam in He operated a currency exchange business, as well as a pedicure and manicure business, both of which he sold by The Minister conducted a net worth audit and reassessed the taxpayer for unreported business income of over $260,000 in 2003 and LEGAL BUSINESS REPORT / JUNE

6 over $110,000 in The taxpayer was also reassessed for unreported GST that flowed from the unreported income, and gross negligence penalties were imposed. The taxpayer appealed to the Tax Court of Canada, claiming that he had received between $200,000 and $250,000 from his mother when he made trips to Vietnam or when his mother s friends visited him in Vancouver. The taxpayer did not keep accurate records, but the Court held that there was no evidence that the taxpayer was carrying on any business activity other than the currency business and the nail salon. As such, the only way the taxpayer could have supported his lifestyle was through the significant sums of money gifted by his mother. Despite the absence of documentation and the lack of corroborating testimony from his mother or his mother s friends regarding the gifts, the Court partially allowed the taxpayer s appeal and ordered that the taxpayer s income be reduced to reflect the gifts from his mother in the amount of $125,000. The amount of GST assessed and the penalties imposed were also reduced accordingly. 5. Docherty v. The Queen, 2010 DTC 1063 In this Tax Court of Canada case, the taxpayer had reported income of around $20,000 in 2001 and $21,000 in 2002, but had purchased two properties for a total cost of nearly $600,000 in Consequently, the Minister performed a net worth assessment and reassessed the taxpayer for unreported income of over $22,000 and $152,000 for the 2001 and 2002 taxation years respectively. The taxpayer challenged the Minister s reassessment, contending that she received the additional funds from friends of her father ( family friends ) and family members for the purpose of purchasing two properties as homes for her family. To bolster her claim, the taxpayer s father testified that the taxpayer inherited $40,000 from her great-grandfather s estate, and was also gifted $30,000 by her grandmother, who had inherited the remainder of the cash from that estate. The taxpayer s father also confirmed that each of the family friends gifted $10,000 to the taxpayer to enable the taxpayer to purchase a home. This was further supported by a letter written by the family friends, which indicated their intention to advance a total of $30,000 to the taxpayer. This letter added to the credibility of the taxpayer s father as it correctly noted that one of the family friends would be the indemnitor of the mortgage obtained for one of the properties. Additionally, the taxpayer s bank statements showed that cheque deposits totalling $30,000 were made soon after the letter was written. LEGAL BUSINESS REPORT / JUNE

7 Despite the fact that the taxpayer (i) kept insufficient records to properly establish where the funds came from, (ii) did not call the family friends as witnesses in order to provide verbal testimony on the gifts they made; and (iii) acted in a hostile, rude and unreasonable manner in her dealings with the auditor of the CRA, the Court allowed the taxpayer s appeal. The Court accepted that the taxpayer s family and family friends had provided some of the money that made it possible for the taxpayer to purchase the two above-mentioned properties. As a result, it was held that the amount of unreported income, as well as the gross penalties that were imposed, should be reduced accordingly. 6. Kozar v. The Queen, 2010 DTC 1251 In this Tax Court of Canada case, the taxpayer was employed full time as a registered nurse and reported income of close to $45,000 in 2001 and over $42,000 in Following a CRA audit of the taxpayer s husband s satellite receiver decoding business, the CRA expanded their investigations to the taxpayer. Due to (i) unexplained bank deposits of over $76,000 in 2001 and nearly $11,000 in 2002 into the taxpayer s bank accounts, (ii) the cash nature of the taxpayer s husband s business, and (iii) the allegation by the CRA that the taxpayer was not co-operative throughout the audit, the Minister conducted a net worth assessment and reassessed the taxpayer for unreported amounts in excess of $220,000 and $135,000 for the 2001 and 2002 taxation years respectively. The Minister claimed that the taxpayer had received these amounts of unreported income as an employee of her husband s business. The taxpayer appealed the Minister s reassessment and provided evidence that (i) she was not an employee of, and received no funds from, her husband s business; and (ii) the funds alleged by the CRA to be unreported income were received from nontaxable sources that arose from her wedding. Firstly, the Court found that the fact that the bank deposits were not made on a periodic payment basis nor in identical amounts reinforced the taxpayer s claim that she was not an employee of her husband s business. The Court also held that the testimony by the taxpayer and her co-worker regarding the taxpayer s computer illiteracy and lack of time to work at her husband s business very credible. The taxpayer had general knowledge of her husband s business, such as the business hours, names of employees and the person in charge of the cash payments. However, this evidence, by itself, is not determinative of whether the taxpayer was employed at her husband s business. Furthermore, by finding that over $100,000 was received as gifts from her wedding, the Court held that the taxpayer had successfully demolished the Minister s assumption that the discrepancies in her net worth were solely attributable to her employment at her husband s business. The value of gifts received by the taxpayer was LEGAL BUSINESS REPORT / JUNE

8 supported by credible witnesses and supporting documentation. Given the overwhelming evidence that strengthened the taxpayer s claim, and the lack of reasonable proof to the contrary, the Court allowed the value of wedding gifts, engagement shower gifts and a honeymoon gift to be removed from the calculation of the taxpayer s net worth. The Court allowed the taxpayer s appeal based on the following reasons: (i) the taxpayer led direct evidence as to the source of the unexplained deposits and proved, beyond a balance of probabilities, that the funds did not originate from employment at her husband s business; (ii) the taxpayer s testimony was credible, without any large gaps in logic, chronology or substance; (iii) the Minister had very little evidence from which to proceed to a net worth analysis; and (iv) despite the initial reluctance by the taxpayer to provide information, the sheer volume of material that was eventually provided demonstrated that the taxpayer co-operated more fully than the CRA had a right to expect or demand. (ii) PROCEEDS FROM GAMBLING A net worth assessment can also be successfully challenged on the grounds that the increase in net worth is attributed to non-taxable casual gambling gains. Note that net worth assessment will only be reduced on account of non-taxable gambling gains if such gambling or betting activities can be shown to be casual form of amusement (i.e. a hobby). If, however, such gambling gains amount to the carrying on of a business activity by the taxpayer, then the profits are taxable. To ascertain whether gambling proceeds are the result of a business activity and are thus taxable, the Court will look at whether the gambling proceeds are the product of an organized system of winning akin to a business. If, on the other hand, the taxpayer s wins are the result of luck then the Court will find that the gambling proceeds are not taxable, even if it is shown that the taxpayer is a frequent gambler and has won large sums of money. In the absence of satisfactory documentation, the Court may give weight to the testimony of the taxpayer and other witnesses who have personal knowledge of the taxpayer's gambling activities. 1. DiCosimo v. M.N.R, 51 DTC 372 In this Tax Appeal Board case the taxpayer challenged the net worth assessment on the basis that it included non-taxable gambling profits. The taxpayer was an owner of a modest restaurant who showed an increase of approximately $17,000 in his capital account in his tax return. He attributed this increase to gambling gains. The Minister LEGAL BUSINESS REPORT / JUNE

9 was not satisfied with the taxpayer's explanation and determined that tax be paid on this amount. The taxpayer appealed this decision. The taxpayer did not provide documentation which attested the increase resulted from gambling profits, but he testified that he had won the $17,000 on two successive nights playing dice. Four witnesses who observed the taxpayer gambling and winning on these nights also corroborated his testimony. While there were a few discrepancies between the testimony of the witnesses, they corroborated each other and the taxpayer on the main facts. The Court accepted gambling profits as the explanation of the taxpayer's increase in net worth and reduced the Minister's net worth assessment accordingly. In doing so, the Court held that where a taxpayer produced reliable witnesses to prove gambling gains it may be accepted as an explanation of net worth increase. 2. Epel v. The Queen, 2003 DTC 1361 The taxpayer, in this recent 2003 Tax Court of Canada case, was audited in respect to the tax returns that he filed for four consecutive years. The Minister performed a net worth assessment for these years and increased the amount of income the taxpayer claimed for these four years and imposed penalties. In addition, the taxpayer had altogether failed to file tax returns for the following three years. As a result, the Minister performed an assessment for these years as well. The taxpayer appealed this assessment, claiming that the increase in assets was largely attributed to non-taxable income, including gains from casual gambling. The taxpayer operated a shoe repair business in Canada. He emigrated from Russia approximately ten years earlier. He had very little formal education, could not read or write, and had a very basic ability to speak English. As the taxpayer kept no records of his winnings or losses, he offered testimony that he used gambling as a form of entertainment because his poor English skills denied him of the pleasure of watching theatrical productions and films. He testified that he was a frequent casual gambler who went to casinos to have fun, meet people and drink. He claimed that he won much more frequently than he lost as a result of luck, and not from an organized system of winning. The two witnesses, including the owner of the casino he frequented and the owner's wife corroborated the taxpayer's testimony. Both of these witnesses claimed that the taxpayer was a fixture in the casino and in a good week could win upwards of $4000, but that he was winning as a result of luck. LEGAL BUSINESS REPORT / JUNE

10 The Court found that although the taxpayer's wins were substantial, the testimonial evidence suggested that these wins were a result of beginner's luck and were not akin to a business operation. As such the Court held that the net worth assessment should be reduced to account for the non-taxable income the taxpayer derived from casual gambling. (iii) COST OF LIVING DEFENCE The personal expenditures that are factored into the net worth assessment are estimated on the basis of StatsCan expenditure figures (consumer price index). In general, the Courts have indicated that the method of using StatsCan figures is unsatisfactory, as these figures are simply national averages and do not accurately reflect the precise cost of living for every taxpayer. Thus, the taxpayer has the ability to disprove the estimate by presenting evidence to the contrary. The amount the Minister allocates to personal and living expenses will be reduced if the taxpayer can provide satisfactory evidence that the taxpayer's living expenses were lower than the Minister's estimate. 1. Bigayan v. The Queen, 2000 DTC 1619 In this Tax Court of Canada case, the taxpayer was a sole proprietor of a business which did building maintenance and small appliance repairs. The taxpayer filed tax returns for three consecutive years in which he declared an extremely low income. The Minister performed a net worth assessment for these years because he concluded that the taxpayer and his family could not have lived on the income he declared. The taxpayer appealed contending that the net worth assessment should be reduced to take into account the (i) inaccuracy of the Statistics Canada cost of living estimate; and (ii) litigation settlement funds obtained by the taxpayer. The Minister used figures from StatsCan to estimate the taxpayer's cost of living expenses. The taxpayer claimed that these figures were excessively high and did not accurately reflect his lower living expenses. However, the taxpayer presented little evidence to rebut the StatsCan figure, only estimates which differed quite substantially from his original estimates in his earlier tax returns. The Court indicated that using the StatsCan figures in net worth assessments is a highly unsatisfactory method which is inherently unreliable. However, since the taxpayer only provided questionable estimates in his attempt to demolish the StatsCan LEGAL BUSINESS REPORT / JUNE

11 figures the net worth assessments, the Court did not reduce the Minister's assessment in respect to the taxpayer's personal expenditures. 2. Cox v. The Queen, 2002 DTC 1515 In this case, in which the facts were previously set out in this issue of Legal Business Report, the taxpayer, who was a diagnosed paranoid schizophrenic, raised the cost of living defence. The taxpayer, who was represented by Alpert Law Firm, claimed that the Minister's estimate of his cost of living was too high. In the absence of documentation that contradicted the cost of living estimate in the Minister's net worth assessment, the taxpayer produced evidence that his lifestyle was extremely meagre and did not conform to the average StatsCan norm that the Minister used. The judge considered the taxpayer's unkempt appearance and psychiatric problems in deciding that the taxpayer's personal expenses, were considerably lower than the StatsCan norm used in the assessment. As a result, the Court lowered the net worth assessment to account for the taxpayer's reduced cost of living expenses for food, clothing, household operations, personal care, recreation, reading materials and gifts. 3. West v. The Queen, 2007 DTC 7 The Minister reassessed the taxpayer using the net worth method for the years 1999 to 2001, for which his reported income was nil, and for 2002, for which no tax return had been filed. The taxpayer was a young unemployed, under-educated male who lived during these years with his mother or alternately, with various unidentified girlfriends. His mother and from time to time, his father, kept him in spending money and provided him with the necessities of life including food, clothing and personal care items. The Tax Court found that the taxpayer's lifestyle was below that of the single Canadian contemplated by Statistics Canada: he had never been to a dentist, did not wear glasses, did not drink or smoke, did not contribute to charity, and relied on friends and his mother for his entertainment needs. Thus, the Tax Court rejected entirely the amounts attributed to each of the Appellant's taxation years using the net worth method, holding that the taxpayer's sole source of funding was given to him or provided by other taxpayers. LEGAL BUSINESS REPORT / JUNE

12 This issue of the Legal Business Report is designed to provide information of a general nature only and is not intended to provide professional legal advice. The information contained in this Legal Business Report should not be acted upon without the further consultation with professional advisers. Please contact Howard Alpert directly at (416) if you require assistance with tax and estate planning matters, tax dispute resolution, tax litigation, corporate-commercial transactions or estate administration. No part of this publication may be reproduced by any means without the prior written permission of Alpert Law Firm Alpert Law Firm. All rights reserved. LEGAL BUSINESS REPORT / JUNE