How To Deal With A Cryptocurrency Tax Audit: Guidance From A Canadian Tax Lawyer – Tax Authorities

The Canada Revenue Agency (CRA) is increasing its scrutiny of
cryptocurrency tax returns

Many tax agencies and regulatory bodies around the world have
increasingly focused on cryptocurrency traders for the past several
years, in particular the IRS and the CRA. One challenge a tax
agency often faces is the anonymous nature of the cryptocurrency
transactions, which makes it different to identify the taxpayers
for a Canada crypto tax audit. In 2016, IRS filed a
generic request known as the “John Doe” summons on all
Coinbase’s US users who transferred bitcoins between 2013 to
2015. Unsurprisingly, in March 2021, the Federal Court of Canada
issued an order allowing the CRA to require Coinsquare Ltd. which
is Canada’s largest cryptocurrency exchange, to provide certain
information related to cryptocurrency traders. Despite
Coinsquare’s initial effort to fight the order, it eventually
reached an agreement with the CRA to turn over certain user
information dating back to 2014. With such information and the
shared taxpayers’ information from the IRS, the CRA will
certainly uncover some taxpayers who failed to disclose their cryptocurrency
transactions, which will lead to more crypto tax audits.

Common CRA cryptocurrency audit questions

The CRA has been sending crypto tax audit questionnaires to
taxpayers that is 13 pages long and has 54 questions. These
questions typically involve investments, mining history, assets,
wallets and other related subjects. Some sample questions from the
CRA’s crypto tax audit questionnaire are as follows:

• When did you start getting involved in the cryptocurrency
  space, and how did you get involved?




• Do you invest in cryptocurrencies and/or mine cryptocurrencies?
  Are you involved within the space in any other way (i.e. advisor,
  teacher, cryptocurrency ATM service provider, selling hash power,
  running an exchange, part of a mining pool or any other business
  venture related to the space?




• Do you use any cryptocurrency mixing services and tumblers? If
  so, which services do you use? Can you please provide us with the
  tracing history, along with all the cryptocurrency addresses you
  “mixed”? Why do you use these services?




• Do you use shapeshift exchange or changelly? If so, please
  provide us with the cryptocurrency addresses you’ve used to
  trade with and the dates you made these particular “swap”
  trades.




• Can you tell us about all the cryptocurrencies that you own?
  Provide us with a timeline of when you made each purchase from fiat
  to crypto.

Tax treatment of cryptocurrency gains

The tax treatment of gains from cryptocurrency transactions such
as trading or mining depends on facts and the circumstances of that
particular individual.

For individuals who engage in crypto trading, the gains can be
treated either as business income or capital gains. The
characterization mainly depends on the intention at the time, and
is reflected by other factors set out in Happy Valley
Farms:

• the frequency of the transactions;




• the duration of the holdings;




• the intention to acquire the securities for resale at a
  profit;




• the nature and quantity of the securities; and




• the time spent on the activity.

As for cryptocurrency mining, the two main possible
characterizations for the activity are as a personal hobby or as a
business. Case law indicates that in order for an activity to be a
business, the taxpayer’s predominant intention in carrying out
the activity was to make a profit and that the activity was carried
out in accordance with the objective standards of businesslike
behaviour. On the other hand, if the personal elements in the
activity outweigh the extent to which the taxpayer carried out the
activity in a commercial manner, then the activity is a hobby not a
business.

Pro Tax Tips – How to prepare for a cryptocurrency tax
audit

A crypto investor or trader should keep records when you
purchase, dispose, or mine cryptocurrency to ensure you have
accurate information about your activities. A taxpayer who does not
keep proper financial cryptocurrency records will be at the
CRA’s mercy during a cryptocurrency tax audit. Therefore, a
taxpayer should generally maintain the following cryptocurrency transaction records but not
limited to:

• date of the transaction




• the cryptocurrency addresses




• the transaction ID




• receipts for the purchase or transfer of cryptocurrency




• value of the cryptocurrency in Canadian dollars when you made
  the transaction




• a description of the transaction and the other party (such as
  their cryptocurrency address)




• exchange records




• wallet records




• accounting and legal costs




• software costs related to managing your tax affairs

If you are a miner of cryptocurrency, you should also keep the
following records:

• receipts for purchasing cryptocurrency mining hardware




• receipts to support your expenses associated with the mining
  operation




• the mining pool contracts and records




• any other records on the mining activities




• the disposal of cryptocurrency earned through the mining
  activities

However, a taxpayer is not required to answer every question a
CRA crypto tax auditor poses. In MNR v Cameco Corporation,
2019 FCA 67, the Federal Court of Appeal confirmed that the CRA did
not have the power to compel a taxpayer to answer questions at the
tax audit stage. Still, a taxpayer should understand if they choose
to not to answer questions during a cryptocurrency tax audit, the
CRA may draw an unfavourable conclusion and propose further
penalties. A taxpayer should never deal with the CRA directly, and
it is highly recommended that a taxpayer retains an experienced
Canadian crypto tax lawyer to prepare the CRA cryptocurrency audit questionnaire
responses and to deal with CRA. If an accountant is required, a
Canadian tax lawyer can then retain an accountant on the
taxpayer’s behalf and extend the solicitor-client
privilege.

FAQ:

Does a taxpayer need to answer all questions posed by a
crypto tax auditor?

The CRA cannot compel taxpayers to answer questions at the
crypto tax audit stage. However, if a taxpayer refuses to answer
certain audit questions, the CRA to draw an unfavourable inference
and may propose further penalties. Therefore, the best way to
prepare for a cryptocurrency tax audit is to maintain proper
financial records and to retain an experienced Canadian cryptocurrency tax lawyer to assist you with
the crypto tax audit process.

What is the voluntary disclosure program? How would it
benefit a taxpayer?

A voluntary disclosure application is designed for taxpayers who
failed to disclose their income or made errors in their previous
tax returns to come clean and fix their mistakes. A taxpayer must
meet the five conditions to qualify for the voluntary disclosure program. The taxpayer may
be exempt from penalties and receive partial interest relief under
certain conditions if accepted.

I am being subjected to a crypto tax audit. What are the
possible outcomes?

A crypto tax audit may lead to an assessment or reassessment
with additional amounts of tax. The CRA will almost always impose a
gross negligence penalty with 50% of extra tax if it believes a
person has knowingly or in circumstances amounting to gross
negligence, made or participated in the making of a false statement
or omission in a return. If the CRA thinks a taxpayer has committed
tax evasion by falsifying records and claims, it will likely start
a criminal investigation which may lead to criminal tax
prosecution.

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.