Raymond Stewart & Pansy Halls: Net worth audits and appeals to the Tax Court of Canada

  • 13 juin 2022
  • Milosz Zak, Associate, Farber Tax Law

On December 22, 2021, the Tax Court of Canada (the “Court”) published its decision in Raymond Stewart v Her Majesty The Queen,[1] which resulted in the removal of subsection 163(2) of the Income Tax Act [2](the “ITA”) gross negligence penalties levied against he appellant and allowed substantial subcontractor expenses in the context of a net worth audit. A few months after, on April 4, 2022, the Court published its decision in two informal procedure appeals, Pansy Halls v Her Majesty The Queen,[3] which dealt with a net worth audit of an unincorporated restaurant business owned by two spouses. While Stewart did not challenge the net worth methodology but rather the correctness of the adjustments, Pansy Halls focused on the fairness of the Canada Revenue Agency’s (the “CRA”) net worth audit approach, without success. Although the Pansy Halls decision has little precedential value because it was appealed pursuant to the Tax Court of Canada Rules (Informal Procedure),[4] it, along with the decision in Stewart, provides a succinct overview of net worth audits.

What are net worth audits?

The net worth technique measures an individual’s total income based on personal and business assets and liabilities at two points in time, after having taking into account personal expenditures and other adjustments. Net worth audits result in a series of “factual” assessments. These assessments are based on a CRA auditor’s high-level review of the available documentation but are often incorrect as they may impute non-taxable amounts, inter-account transfers, and omit assets and liabilities, which would have otherwise lowered the year-over-year discrepancy in the net worth. Net worth assessments, although often acknowledged as arbitrary and imprecise by the Court,[5] should follow the principles of “conservatism” because the audit may not catch all cash transactions, unless they are deposited. A common argument raised in a net worth audit is that an auditor neglected to follow the principle of conservatism to arrive at a credible and reasonable conclusion. Further, the perceived unfairness is considered resolved by the fact that the taxpayer is in the best position to know their true taxable income and be able to correct any of the Minister’s errors.[6] The result of a net worth audit is often an increase in unreported taxable income, an increase in GST/HST collectible, and the application of gross negligence penalties.

Pursuant to the Supreme Court of Canada’s decision in Hickman Motors Ltd. v Canada,[7] the Minister, in making the assessments, proceeds on assumptions.[8] The Minister is permitted to make assumptions, while the initial onus of “demolishing” the Minister’s exact assumptions is met where the appellant makes out at least a prima facie case.[9] The Minister’s unsubstantiated and unproven assumptions should not be transformed into “factual findings”; the Minister should be able to rebut the taxpayer’s prima facie evidence and bring forth some foundation for the Minister’s assumptions.[10] Because simple assumptions are insufficient, the CRA issues audit questionnaires and requests documentation.

If the CRA auditor incorrectly assumes figures for a taxpayer’s assets, liabilities, and personal expenditures, based on the available information and documentation, it has been well established the onus is on the taxpayer to rebut the Minister’s assumptions in the net worth assessments.[11] Further, pursuant to subsection 152(8) of the ITA,[12] and subsection 299(4) of the Excise Tax Act[13] (the “ETA”) assessments are deemed valid and binding, unless the taxpayer shows otherwise.

In Pansy Halls, the appellants were unable to effectively rebut the Minister’s assumptions and were ultimately unsuccessful in their appeals. On the other hand, in Stewart, the appellant was able to demonstrate that a barn-painting business required sub-contractors, that the appellant and two cousins received payments in-kind or through cash, and that an approximation ought to be made for such sub-contractor expenses, reducing the net worth adjustments. Additionally, the Court vacated the subsection 163(2) of the ITA gross negligence penalties in Stewart, because it believed the appellant’s honest testimony that the barn painting business was in its first years, and that the appellant, as an elderly person, was completely unaware of the proper way to report his farm and barn painting business for tax purposes.[14]