Back in the summer of 2018, the Canada Revenue Agency ("CRA") promised to expose those who evade tax by using cryptocurrencies such as Bitcoin, Litecoin, Ethereum, Dash, Zcash, and Ripple. At that time, the CRA boasted advances in international cooperation aimed at fighting international tax crime and money laundering.
The Canada Revenue Agency has now sent out its first round of audit letters. And Canadian cryptocurrency investors and traders are feeling the heat as the CRA makes good on that year-old promise to conduct tax audits of cryptocurrency traders.
After reviewing the expanded resources allowing the CRA to more readily identify cryptocurrency users, this article discusses the tax-audit questionnaire that various Canadians have received about their cryptocurrency activities. We then review some of the tax implications of which Canadian cryptocurrency users ought to be aware. This article concludes by providing tax tips that Canadian cryptocurrency users may find helpful.
Canada Revenue Agency's Augmented Ability to Identify Cryptocurrency Traders & Investors: The Joint Chiefs of Global Tax Enforcement (J5)
On July 3, 2018, the CRA joined the Joint Chiefs of Global Tax Enforcement (J5), a joint international effort aimed at investigating cryptocurrency-related tax evasion and money laundering, which may involve users of Bitcoin, Dodgecoin, Litecoin, Monero, Ethereum, Namecoin, Bytecoin, or Ripple.
In addition to the Canada Revenue Agency, the J5 includes tax administrators from Australia, the Netherlands, the United Kingdom, and the United States of America. The J5's mandate includes information sharing and joint investigations to combat the threat of cryptocurrencies on tax administration in the member countries. In particular, the project seeks to uncover taxpayers' unreported income and assets from holdings in Nxt, Monero, Ether, Peercoin, Swiftcoin, Tether, and other cryptocurrencies.
The group's formation has unsurprisingly caused a stir among cryptocurrency users in Canada, Australia, the Netherlands, the United Kingdom, and the United States of America. In particular, the J5's creation was an advanced signal of what we are now seeing: increased efforts by tax authorities to gain insight on cryptocurrency transactions. For example, efforts like those of the United States Internal Revenue Service (IRS), who, in early 2018, successfully compelled the digital-wallet provider, Coinbase, to surrender the account information of over 14,000 users who dealt in Bitcoin. Indeed, efforts such as these very likely explain the Canada Revenue Agency's ability to target Canadian residents for cryptocurrency-related tax audits.
The CRA's In-Depth Cryptocurrency Initial Interview Questionnaire
The CRA typically begins its tax audit process by issuing a letter notifying the taxpayer about the pending audit, the tax years or reporting periods under audit, and the general subject matter of the audit. These letters often include an initial questionnaire.
The Canadian taxpayers, whom the CRA selected for a cryptocurrency audit, received a 13-page questionnaire entitled "In-depth Cryptocurrency Initial Interview Questionnaire." It includes 54 questions, some of which are multi-part questions.
The questionnaire asks taxpayers to discuss topics such as:
- The timeline of their cryptocurrency dealings;
- The source of the cryptocurrencies purchased;
- The use of third-party exchange wallets;
- The source of funds used to purchase cryptocurrency;
- Transaction record-keeping practices of the taxpayer;
- Participation in initial coin offerings (ICOs);
- Whether any cryptocurrency holdings generate passive income for the taxpayer (e.g., Node, Masternodes, Supernodes, etc.);
- Participation in cryptocurrency mining (including questions about the sort of mining hardware used and energy expenses related to mining);
- Acceptance of cryptocurrency as payment for goods or services;
- The frequency of cryptocurrency transactions; and
- The time spent studying cryptocurrency markets.
As you'll notice from the discussion below, these questions tie into various considerations that prove relevant for discerning not only whether the taxpayer reported the income but also whether the taxpayer reported the income correctly.
Canadian Tax Consequences of Cryptocurrency Transactions: An Overview
The development of the J5 and the recent audits pursued by the Canada Revenue Agency should alert users of Ethereum Classic, Titcoin, Decred, Petro, NEM, MazaCoin, and other cryptocurrencies about the need to educate themselves on the tax-compliance requirements in their jurisdiction. Some cryptocurrency users, for instance, erroneously believe that they need not worry about tax liability until they cash out into fiat (conventional currency). This is false. Discuss the Canadian tax implications of your cryptocurrency transactions with one of our expert Canadian tax lawyers.
This section provides a basic overview of some of the Canadian tax implications of which those who trade cryptocurrency should be aware.
To date, the Canada Revenue Agency treats Bitcoin—and cryptocurrencies generally—as a commodity for income-tax purposes. As a result, the CRA will subject cryptocurrency transactions in Canada to the same rules that it would apply to barter transactions.
This generally means that a gain or loss from a cryptocurrency transaction will be treated as either (i) income or loss from a business or (ii) a capital gain or loss. The difference comes with important tax implications. The full amount of business income is taxable, while only one-half of a capital gain is taxable. The corollary is that, while only one-half of capital losses are deductible, one may fully deduct business losses.
Yet it's not always entirely clear which treatment should apply. Some cryptocurrency transactions—such as trading, investing, and speculating—may straddle the line between income and capital. Unsurprisingly, Canadian courts have amassed a large body of case law labouring over the ambiguity between investing, which produces a capital gain or loss, and trading, which results in business income or expenses.
To assess whether the proceeds from a cryptocurrency transaction are business profits or capital gains, a court will ultimately examine a wide range of factors—including, the frequency of transactions, the duration of ownership, the taxpayer's knowledge of the cryptocurrency market, the relationship of the cryptocurrency transaction to the taxpayer's usual work or business, the time the taxpayer spends on cryptocurrency activities, and whether the taxpayer obtained financing to participate in the cryptocurrency transaction.
The same considerations apply when a taxpayer mines Bitcoin or other cryptocurrencies. A person who mines cryptocurrencies may be thought of as either acquiring a capital property or earning business income. If thought of as acquiring a capital property, the miner's adjusted cost base would be the cryptocurrency's fair market value at the time of acquisition. Also, since crypto-mining demands considerable computing resources, a bitcoin's adjusted cost base would presumably include the cost of generating the computer power necessary to acquire the coin. The miner thus incurs a capital gain or loss depending on the cryptocurrency's value upon disposition. On the other hand, if thought of as earning business income, the miner's income is the cryptocurrency's fair market value at the time that the miner uncovered the unit. If the miner later sells the uncovered cryptocurrency for an amount greater than its value, the excess is also included in business income. Also, because crypto-mining requires you to devote extensive computing resources to the endeavour, these costs presumably should constitute a deductible business expense.
Tax Tips: Unreported Cryptocurrency Income & Legal Opinion on Proper Tax-Return Filing Position
The Canada Revenue Agency's cryptocurrency audits signal the end of the past anonymity offered through the use of Bitcoin, Auroracoin, Dash, Synereo AMP, PotCoin, Nxt, Gridcoin, Feathercoin, and other cryptocurrencies. This should definitely concern Canadian taxpayers with unreported profit from cryptocurrency transactions. A confidential and privileged consultation with one of our expert Canadian tax lawyers can assist you in completing the tax audit questionnaire and provide you with advice on remedying past non-compliance a voluntary disclosure program (VDP) application for relief of tax penalties and avoidance of criminal tax prosecution.
Our Canadian tax lawyers can also advise you on the proper reporting of your cryptocurrency profits to ensure that CRA doesn't fault you for misrepresenting the information in your tax returns. You may, for example, benefit from a tax memorandum examining whether your cryptocurrency profits should be reported as capital gains or business income.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.