Introduction – International Tax Coalition Targeting Cryptocurrency
In the summer of 2018, an international coalition of tax administrators—including the Canada Revenue Agency (CRA) and the United States Internal Revenue Service (IRS)—promised to pool their resources and expose cryptocurrency users who dodged their tax obligations.
Since then, the CRA, the IRS, and other tax administrators have only fine-tuned the strategies allowing them to identify cryptocurrency users for tax audit or prosecute them for tax evasion. In 2019, for instance, many Canadian cryptocurrency users were shocked to receive a 13-page CRA questionnaire about their cryptocurrency transactions. In the United States, the IRS has successfully compelled at least one digital-currency exchange to turn over its users' account information, and the early release draft of the 2020 individual income-tax return (Form 1040) bluntly asks US taxpayers to reveal any dealings in virtual currency. Tax authorities have also expanded efforts to criminally prosecute those who evade tax by using cryptocurrencies such as Bitcoin (BTC), Bitcoin Cash (BHC), Litecoin (LTC), Ethereum (ETH), Chainlink (LINK), Dash, Zcash (ZEC), and Ripple (XRP).
After discussing some of the resources allowing the Canada Revenue Agency to more readily identify, audit, and prosecute cryptocurrency users, this article provides tax tips that Canadian cryptocurrency users may find helpful.
International Cooperation Allowing the Canada Revenue Agency to Identify Canadian 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.
The J5 includes not only the Canada Revenue Agency but also tax administrators from Australia, the Netherlands, the United Kingdom, and the United States of America. The J5's mandate focuses on information sharing and joint investigations that aim to address the challenges that cryptocurrencies present for tax administrators in its member countries. In particular, the project seeks to uncover taxpayers' unreported income and assets from holdings in Bitcoin SV (BSV), Tether (USDT), Monero (XMR), EOS, Binance Coin (BNB), and other cryptocurrencies, such as Facebook's soon-to-be-released Libra (LIBRA).
The group's formation signaled a coordinated effort by tax authorities to gain insight on cryptocurrency transactions involving taxpayers in Canada, Australia, the Netherlands, the United Kingdom, and the United States of America.
Resources and Inspiration from Advancements by the IRS
The US Internal Revenue Service has seemingly taken the lead on pursuing sources of information about cryptocurrency transactions. In 2017, for example, the IRS obtained a court order requiring the virtual-currency exchange, Coinbase, to surrender information about any user whose account had "at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013 to 2015 period." For each account meeting that description, the IRS received the account user's name, taxpayer ID number, birth date, address, and records of account activity, including detailed transaction logs and the name of the counterparty to each transaction (see: United States v. Coinbase, Inc., Case No.17-cv-01431-JSC). The court order affected over 14,000 Coinbase users.
Nowadays, the IRS, the Canada Revenue Agency, and other tax administrators have no difficulty tracing transactions involving mainstream cryptocurrencies, like Bitcoin. Bitcoin's open-ledger blockchain system allows tax authorities to identify users with relative ease. But the IRS is now actively seeking the tools to investigate transactions involving the following:
- privacy coins—e.g., Monero (XRM), Zcash (ZEC), Dash (DASH), Grin (GRIN), Komodo (KMD), Verge (XVG), Horizon (ZEN);
- Layer 2 off-chain protocol networks—e.g., Lightning Network (LN), Raiden Network, Celer Network; and
- side-chains—e.g., Plasma and OmiseGo.
The IRS has offered up to $1 million to any developer that creates tracking technology for privacy-focused cryptocurrencies and new blockchain tech,
The IRS has also adopted mandatory cryptocurrency reporting for US taxpayers. For the 2020 tax year, the US individual income-tax return (Form 1040) will require taxpayers to disclose their cryptocurrency dealings. US taxpayers will see the following question, just underneath the address line on their Form 1040: "At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?" This new inclusion certainly heightens the stakes for cryptocurrency users who would otherwise have embraced the play-dumb-and-hope-for-the-best strategy of tax filing. (The IRS did in fact include a cryptocurrency question in 2019, but it appeared on the additional-income form, Schedule 1, which many Americans don't submit.)
And the IRS has enjoyed some public success in pursuing cryptocurrency users who evade tax. Cryptocurrency and tax evasion made headlines when, on October 6, 2020, the anti-virus software developer John McAfee was arrested in Spain for tax-evasion charges that he faced in the United States. The US Justice Department alleges that McAfee dodged US taxes by routing his income to cryptocurrency-exchange accounts in the names of nominees. According to the indictment, from 2014 to 2018, McAfee filed no tax returns yet earned millions from several ventures, including cryptocurrency trading.
Make no doubt, the IRS's advancements will inspire and benefit the Canada Revenue Agency's efforts to identify, tax audit, and prosecute Canadian cryptocurrency users. The CRA may soon take the IRS's lead and require Canadian taxpayers to disclose any cryptocurrency dealings. Furthermore, the Canada Revenue Agency enjoys direct access not only to the data that the IRS gathers from cryptocurrency-tracing tech but also to the records that the IRS squeezes out of any cryptocurrency exchange. The CRA and the IRS mutually exchange taxpayer information by virtue of their participation in both the J5 and the Canada-US Tax Treaty. Article XXVII of the Treaty obligates the two countries to exchange any information that may be relevant to enforcing either country's tax laws. Indeed, this flow of information very likely helped the Canada Revenue Agency pinpoint Canadian taxpayers for a cryptocurrency audit.
The CRA's Cryptocurrency Tax-Audit Questionnaire
The CRA typically begins a tax audit 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.
If selected for a CRA cryptocurrency tax audit, Canadian taxpayers receive a 13-page cryptocurrency-audit questionnaire, which includes over 50 questions on a range of topics, such as:
- The timeline of owing or using cryptocurrency;
- 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.
The taxpayer must also turn over bank-account statements and any other records allowing the CRA tax auditor to verify the taxpayer's answers.
Pro Tax Tips: Record-Keeping, Legal Opinion on Proper Cryptocurrency Tax Reporting, Voluntary Disclosures Program for Unreported Cryptocurrency Income & Solicitor-Client Privilege
A taxpayer who lacks proper records will fare poorly during a CRA cryptocurrency tax audit. Cryptocurrency traders and investors must keep records of their cryptocurrency transactions. The same is true for businesses that accept cryptocurrency as payment for goods and services.
If you use a cryptocurrency exchange, you should periodically export your transaction information to avoid losing it. Many taxpayers lost all records with the bankruptcy of Quadriga. You should also maintain the following records about your cryptocurrency transactions:
- The date of each transaction;
- Any receipts for purchasing or transferring cryptocurrency;
- The value of the cryptocurrency in Canadian dollars at the time of the transaction;
- The digital-wallet records and cryptocurrency addresses;
- A description of the transaction and of the other party (e.g., the other party's cryptocurrency address);
- The exchange records;
- Records relating to any accounting and legal costs; and
- Records relating to any software costs for managing your tax affairs.
If you mine cryptocurrency, you should keep the following records in addition to your cryptocurrency-transaction records:
- Receipts for purchasing cryptocurrency-mining hardware;
- Receipts for expenses associated with your cryptocurrency-mining operation (e.g., power costs, mining-pool fees, maintenance costs);
- Records about your cryptocurrency-mining operation (e.g., hardware specifications, hardware operation time); and
- The mining pool details and records.
Our Certified Specialist Canadian tax lawyer can provide advice about record-keeping and 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 as business income or as a blend of both. It is also important to remember that an intermediate transaction, such as the purchase of Bitcoin which is then used to purchase a different currency, may itself give rise to a taxable transaction.
The advances and cooperative efforts of tax authorities signal the end of the anonymity that cryptocurrency users thought they once enjoyed. This should definitely concern Canadian taxpayers with unreported profits from cryptocurrency transactions. If you filed tax returns that omitted or underreported your cryptocurrency profits, you risk facing not only civil monetary penalties, such as gross-negligence penalties, but also criminal liability for tax evasion.
You may qualify for relief under the CRA's Voluntary Disclosures Program (VDP). If your VDP application qualifies, the CRA will renounce criminal prosecution and waive gross-negligence penalties (and may reduce interest). A voluntary-disclosure application is time-sensitive, however. The CRA's Voluntary Disclosures Program will reject an application—and thus deny any relief—unless the application is "voluntary." This essentially means that the VDP must receive your voluntary-disclosure application before the CRA contacts you about the non-compliance you sought to disclose. Our experienced Canadian tax lawyers have dealt with many Canadian taxpayers involved with cryptocurrency and can carefully plan and promptly prepare your voluntary-disclosure application. A properly prepared disclosure application not only increases the odds that the CRA will accept your disclosure but also lays the groundwork for a judicial-review application to the Federal Court should the CRA unfairly deny your disclosure.
To determine whether you qualify for the Voluntary Disclosures Program, schedule a confidential and privileged consultation with one of our expert Canadian tax lawyers. The Canada Revenue Agency cannot compel the production of information protected by solicitor-client privilege. In other words, solicitor-client privilege prevents the CRA from learning about the legal advice that you received from your tax lawyer. Your communications with an accountant, however, remain unprotected. So, if you seek tax advice but want to keep that information away from the CRA, you should approach a Canadian tax lawyer first. If an accountant is needed, your Canadian tax lawyer can retain the accountant on your behalf and extend the privilege.
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.