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Taxes Tax assessments based on your net worth: be prepared

Is there anything that keeps you up at night? Do you worry about anything in particular? My friend, Paul, is generally a worrier. "Tim, when you dry off with a towel, dead skin cells cling to its surface, providing protein to feed micro-organisms like Staphylococcus aureus, which can cause infections or even toxic shock syndrome," Paul told me recently. "And you should know that electromagnetic rays emitted from alarm clocks are believed to cause cellular mutation and increase the risk of cancer. How many hours do you sleep every night, Tim? Most people spend over a third of their lives asleep in bed."

The fact is, you probably don't lose sleep over your bathroom towels or alarm clock. The taxman, on the other hand, might be a good reason to lie awake at night – if you don't keep good records and your tax return looks fishy. You see, there's something called a "net worth assessment" that the taxman can use to assess tax. Let me explain.

The assessment

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Picture this. A man owns a business and six rental properties. He's married with three children and they spend in excess of $5,000 each month on costs of living. He reports total income of $3,857 on his personal tax return for a particular year, and $1,807 for the following year. You'd have to wonder how his income could be so low given all that he owns and how much he spends to maintain his household each year. The Canada Revenue Agency (CRA) was wondering the same thing.

This is the case of a taxpayer from Toronto – call him Mr. Smith (not his real name) – who recently experienced a net worth assessment (NWA) by CRA. A NWA is a tool used by the taxman to figure out if someone has been under-reporting their income. CRA might become suspicious if, for example, you own a nice home and drive an expensive car but report a relatively low income each year.

In these cases, CRA has the right to assess tax based on some amount of income that they think makes sense based on your net worth, costs of living and reported income. Specifically, the taxman will do a calculation as follows: First, the change in your net worth (your assets less your liabilities) will be calculated from the beginning of a period to the end. Then an estimate of your cost of living expenses will be made, and this amount will be added to the difference in net worth calculated in the first step. The sum of these amounts is assumed to be your income for that period.

For example, if your net worth on Jan. 1, 2014 was $500,000 and on Dec. 31, 2014 was $600,000, it's assumed you somehow earned $100,000. Add to this the expenses you incurred in 2014 as your costs of living – say, $60,000 – and the taxman would conclude that your income for 2014 should have been $160,000 ($100,000 change in net worth plus $60,000 of expenses). If you had reported, say, $20,000 of income for 2014, CRA might assess another $140,000 on top – to bring your income to the calculated figure.

The defence

Under the Income Tax Act, and in my example above, your income will be assumed to be the $160,000 figure unless you can establish there's an error, defect, or omission in the taxman's assessment. You'll be bound to pay the tax assessed under the NWA unless you file a notice of objection within 90 days from the date CRA mails the assessment to you. Then you'll have to defend your position.

In the case of the Toronto taxpayer above, CRA added about $153,000 to his income for two years. He argued that his father had lent him $90,000 over time to help cover costs of living and invest in some rental properties, so he shouldn't be taxed on that amount. If he had been better organized with proper books and records and had showed when the loan amounts were received, where the proceeds were spent and evidenced the loans by promissory notes, he might have won that battle. But he wasn't, and he lost.

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Finally, other taxpayers have successfully defended against a NWA by arguing that net worth increased due to gifts or inheritances or gambling winnings Finally, you might argue that CRA's estimate of your costs of living is too high.

The key is to be honest with your tax filings, organized, and prepared to answer why your income reported might be lower than expected.

Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management, and founder of WaterStreet Family Offices.

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