A Canadian Tax Lawyer’s Perspective on Gross Negligence Penalties and Net Worth Tax Audits

A Canadian Tax Lawyer’s Perspective on Gross Negligence Penalties and Net Worth Tax Audits

What are Net Worth Tax Audits?

A net worth audit is an indirect tax audit technique used by the Canada Revenue Agency or CRA where it has cause to believe the taxpayer’s usual records are not an accurate reflection of the taxpayer’s income. To conduct a net worth audit, the CRA will examine a variety of documents including bank records, title registries and the records of related taxpayers such as family members or corporations owned by the taxpayer under tax audit. Using this information, the auditor will assess the change in the taxpayer’s assets and liabilities (net worth) over the tax audit period. If this change is not consistent with the taxpayer’s tax reporting it suggests the taxpayer had unreported income and the CRA will reassess the taxpayer for the amounts determined under the net worth tax audit method. 

For more on Net Worth Audits, please see our article on the CRA Net Worth Audit

What are Gross Negligence Penalties? 

Under subsection 163(2) of the Income Tax Act, the CRA can assess a type of tax penalty known as a gross negligence penalty. This tax penalty is applied where a taxpayer either knowingly, or “under circumstances amounting to gross negligence” reports information incorrectly on a tax return or tax form, or omits information on a tax return or tax form. A taxpayer may be assessed for gross negligence penalties where, for instance, the taxpayer fails to report income from work done on a cash basis “under the table” when the taxpayer was aware that income needed to be reported.  

Gross negligence penalties can be quite steep. They are calculated as the greater of:

  1. $100 
  2. The difference between the income tax which resulted from the taxpayer’s reporting and the income tax that should have resulted had the taxpayer reported correctly. 

Our experienced Canadian tax lawyers have caused the CRA to reverse the assessment of gross negligence penalties by advancing arguments such as the taxpayer’s reliance on tax professionals, that the taxpayer had reasonable cause to believe his or her reporting was correct, or that the CRA’s burden of proof to impose these penalties has not been discharged. 

The Application of Gross Negligence Penalties in Net Worth Audit Cases

The CRA’s use of the net worth audit method is generally considered controversial by top Canadian tax lawyers. While the CRA may argue the method is reasonably reliable and the best they can do where the usual records kept by taxpayers cannot be relied on, the results of a net worth audit are almost certainly inexact and inaccurate. The CRA auditor must make assumptions and rely on potentially incomplete third-party documents to complete the audits. Further, the CRA is not required to identify the source of unreported income meaning they may apply incorrect tax treatment to income uncovered during the audit – such as considering a gift taxable.  The Tax Court of Canada has dismissed the use of the net worth audit method in cases where the taxpayer’s records were found to be adequate for use of another audit method, finding the net worth audit method should only be used if no other audit method can be used.  

Despite the deficiencies with the net worth tax audit method, a taxpayer can still be assessed for gross negligence penalties on unpaid taxes assessed as a result of a net worth audit. In fact, the CRA typically will apply gross negligence penalties in these circumstances. In Molenaar v. Canada and Boroumand v. The Queen, the courts found the CRA is not required to determine the source of income during a net worth audit. Once the CRA auditor identifies based on reliable information that there is an error in the income reported and the discrepancy is unexplained, the burden of proof shifts to the taxpayer to demonstrate the source of the income and that it was non-taxable. Therefore, the CRA is entitled to assume where no explanation for the unreported income is presented, that the taxpayer knowingly did not report income or acted grossly negligently in failing to report income.    

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The legal test for gross negligence penalties does not formally require the CRA to consider the magnitude of the unreported income or unpaid tax when imposing the penalty. It even has a minimum threshold for the penalty to capture situations where there is a very small amount of unreported income. However, as a practical matter, the amount of unreported income and discrepancy in resulting taxes is often a consideration. The CRA may argue a large amount of unreported income should have been easily noticed by the taxpayer. Conversely, a relatively small amount of unreported income is often a result of innocent error. 

This consideration of magnitude is especially true when the gross negligence penalties are assessed as a result of a net worth audit.  As stated above, the net worth audit method has been criticized for creating imprecise results. A relatively small discrepancy is arguably just as likely to be an error in the net worth audit as it is to be an error by the taxpayer. For example, in Fry v. The Queen, 2019 TCC 236, the taxpayer was assessed for $6,566 of unreported income in 2013 as the result of a net worth audit. The judge found that this magnitude of unreported income was not sufficient to apply gross negligence penalties given the imprecise nature of a net worth audit.  

The nature of a net worth audit, and the general criticisms of its accuracy allows expert Canadian tax lawyers additional avenues to argue the non-application of gross negligence penalties in net worth audit cases. 

Pro Tip
Pro Tax Tips – Defeating a Net Worth Audit

There are two means of defeating a net worth audit used by our expert Canadian tax lawyers. A Canadian tax lawyer may demonstrate the CRA does not have sufficient cause to use the net worth method by arguing the taxpayer’s records are adequate for use of another tax audit method. Alternatively, a Canadian tax lawyer may assist the taxpayer and their tax accountant in performing a full analysis and challenge of the net worth audit such as by showing the specific sources of non-taxable income or errors in the tax auditor’s methodology. 

Net worth audits are incredibly complex and the added risk of gross negligence penalties means having one of our expert certified Specialist in taxation Canadian tax lawyers assisting in contesting a net worth audit is vital.

F.A.Q. 

What is a net worth audit? 

A net worth audit is an indirect audit technique used by the Canada Revenue Agency or CRA where it has cause to believe the taxpayer’s usual records are not an accurate reflection of the taxpayer’s income. To conduct a net worth audit, the CRA will examine a variety of documents including bank records, title registries and the records of related taxpayers such as family members or corporations owned by the taxpayer under audit. Using this information, the auditor will assess the change in the taxpayer’s assets and liabilities over the audit period and determine if the taxpayer failed to report income. 

What are gross negligence penalties? 

A gross negligence penalty is a penalty applied where a taxpayer either knowingly, or “under circumstances amounting to gross negligence” reports information incorrectly on a tax return or tax form, or omits information on a tax return or tax form.