The net worth method is a tax audit technique used by Revenu Québec when a taxpayer does not have reliable, complete or adequate accounting records. It makes it possible to reconstruct a person’s real income based on the evolution of their financial situation rather than on traditional accounting documents. This approach is based on a simple premise: the increase in an individual’s wealth over a given period must correspond to the income they actually earned, once their personal expenses are subtracted.
An assessment of the actual financial situation
To apply this method, the auditor begins by analyzing the taxpayer’s net worth, that is to say the total value of its assets less all of its liabilities. Assets include bank accounts, registered investments, real estate or vehicles, while liabilities include mortgages, credit card balances or personal loans. This first step allows us to paint a clear picture of the taxpayer’s wealth at the beginning and end of the year in question.
Calculation of essential taxpayer expenses
The auditor then looks at the taxpayer’s cost of living. It evaluates all non-deductible personal expenses incurred during the year, such as groceries, housing, insurance, travel or leisure activities. These expenses are essential to the calculation, since they represent the sums necessary to maintain the taxpayer’s lifestyle and must be financed by taxable income or by a reduction in net worth.
Non-taxable income taken into account
Finally, Revenu Québec takes into account non-taxable income which can explain legitimate enrichment without tax consequences. This could be an inheritance, a monetary donation, a lottery win or even government benefits intended for families. These amounts must be identified and documented, because they make it possible to justify an increase in wealth which does not result from taxable income.
An income verification and reconstitution protocol
The application of the method follows a rigorous protocol. The auditor begins by collecting a vast amount of data: bank statements, purchase contracts, credit documents and other supporting documents spanning several years. Once this information is gathered, it establishes the initial net worth as of January 1 and the final net worth as of December 31 for each of the years checked. It then proceeds to evaluate the lifestyle, based either on invoices provided by the taxpayer, or on regional statistics when personal data is insufficient. From these elements, it reconstructs the taxpayer’s real income. If this estimated income exceeds that declared in the tax returns, the difference is interpreted as undeclared income.
Reversal of the burden of proof
Using the net worth method profoundly transforms the dynamics of a tax audit. It first results in a reversal of the burden of proof: it is up to the taxpayer to demonstrate that Revenu Québec’s calculations are incorrect or that the enrichment comes from a non-taxable source. This inversion places the taxpayer in a delicate position, since he must provide detailed explanations and solid evidence to justify each variation in his net worth. When the explanations are deemed insufficient, Revenu Québec issues new assessment notices in order to recover the evaded tax. These contributions are generally accompanied by interest and, in cases of flagrant omission, penalties of up to 50% of the tax claimed.
The net worth method remains one of the most intrusive and complex tools used by Revenu Québec. It requires exhaustive documentation and the ability of the taxpayer to justify each significant financial movement. For businesses and individuals, understanding how it works is essential in order to better anticipate risks and prepare adequately in the event of an audit.
Martine Dallaire, B.B.A.