Fraud Investigators Identify A Potential $1 Billion Crypto-Based Ponzi Scheme And Target Over 50 Criminal Leads In Canada, The US, The UK, Australia & The Netherlands: Tax Implications For Canadian Taxpayers Who Lose Cryptocurrency Or Non-Fungible Tokens Because Of Fraud

Introduction – International Tax Coalition Targeting Cryptocurrency

In the summer of 2018, an international coalition of tax administrators—including the Canada Revenue Agency (CRA)—promised to pool their resources and expose cryptocurrency users who dodged their tax obligations. Since then, the CRA, the IRS, and other tax administrators had only fine-tuned the strategies allowing them to identify cryptocurrency users for tax audit or prosecute them for tax evasion.

Now, in May 2022, with cryptocurrency markets already on edge following the crash of the purported stablecoin TerraUSD (UST), international tax investigators have identified over 50 leads concerning crypto-related tax crimes, including one case that appears to be a $1 billion Ponzi scheme. Tax administrators also warn of tax fraud and money laundering involving the use of non-fungible tokens (NFTs).

This article first discusses the formation of the international tax coalition known as the Joint Chiefs of Global Tax Enforcement (J5). It then discusses the J5's announcements concerning recently opened tax-fraud investigations involving over 50 specific targets in Canada, the US, the UK, Australia, and the Netherlands. This article then reviews the J5's warnings about red flags indicating potential fraud in NFT transactions. This article then examines the Canadian tax treatment of cryptocurrency losses or NFT losses resulting from fraud, and it concludes by offering pro tax tips from our top tax lawyers in Canada who trade and invest in cryptocurrency or non-fungible tokens.

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 and NFT-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 and non-fungible tokens present for tax administrators in its member countries. In particular, the project seeks to uncover taxpayers' unreported income and assets from holdings in non-fungible tokens and in cryptocurrencies such as Bitcoin (BTC), Bitcoin Cash (BHC), Litecoin (LTC), Ethereum (ETH), Chainlink (LINK), Dash, Zcash (ZEC), and Ripple (XRP).

The group's formation signaled a coordinated effort by tax authorities to gain insight on cryptocurrency transactions and non-fungible-token transactions involving taxpayers in Canada, Australia, the Netherlands, the United Kingdom, and the United States of America.

Over 50 Specific Leads on Crypto-Related Tax Fraud & a $1 Billion Crypto Ponzi Scheme

In May 2022, the J5 disclosed to news-media outlets that it had identified over 50 leads concerning crypto-related tax crimes. The leads come from within each of the J5 countries: Canada, the US, the UK, Australia, and the Netherlands. "Some of these leads concern individuals with substantial NFT transactions involving potential tax or other financial crimes throughout our jurisdictions," noted Jim Lee, the US Internal Revenue Service's Chief of Criminal Investigations. "It looks like one of these leads is a $1 billion Ponzi scheme. That's billion with a 'B,' and this lead affects each J5 country," said Lee.

Tax-crime investigations have already commenced in each country, and news outlets expect an official announcement from the J5 and its members, like the Canada Revenue Agency, imminently.

The J5 Identifies NFT Red Flags to Warn the Public of Risks

On April 28, 2022, the Joint Chiefs of Global Tax Enforcement (J5) released an intelligence bulletin warning banks, law-enforcement personnel, and private citizens of dangers when dealing with non-fungible tokens.

The bulletin, entitled the "J5 NFT Marketplace Red Flag Indicators," lists items that should draw concern when you're dealing with non-fungible tokens or planning to purchase a non-fungible token. The bulletin aims to give banks, law-enforcement officials, and private-industry participants some insight about potential red flags in the NFT marketplace. As the J5 explains, the bulletin isn't meant to be an all-inclusive list of risks associated with NFTs; it represents a list of best practices that the J5 members have compiled from numerous NFT investigations.

This bulletin is "intended to be the first of many that can be used by financial institutions to assist in the fight against tax crime and money laundering involving virtual assets," said Will Day, the Deputy Commissioner of the Australian Taxation Office.

The J5 NFT Marketplace Red Flag bulletin identifies account/transaction attributes that might reveal instances of tax fraud or money laundering. The bulletin classified the following account or transaction attributes as "strong indicators" of fraud:

Newly minted or secondary market transactions exceeding $100,000 with no observable community.
A network of sending and receiving parties to the same transaction or group of transactions—i.e., a tight-knit cluster of digital accounts that transact amongst themselves.
Newly minted non-fungible tokens that are immediately sold at high price points, and those prices don't align with others in the NFT collection.
NFTs that are sold for large sums and then reacquired for far less from the same party (or from a third party).
Frequent turnover of low-value NFTs. The bulletin cited the NBA's Top Shots NFTs in an example: "on Top Shots with the NBA you see a lot of low value (i.e. sub 10K) NFTs being bought in the same day with owners only holding their position for minutes. This could be a way to wash funds."
A clearly overpriced or underpriced NFT that is traded frequently in a brief window of time.
Wash trading—that is, artificially increasing the sale value with each sale between linked accounts.
Incorrect mint address: The contract address doesn't match the address provided on the NFT project's website.
The requirement to provide an Ethereum wallet seed phrase (recovery phrase) plus the MetaMask wallet address before the transaction can be executed.
Phishing scams: fake NFT offers sent by email.
Fake token giveaways or airdrops.
Social-media impersonation—that is, unverified accounts that have no active followers.
Copycat NFT collections, which are used as an exploit for fraud.
Price: If there's a huge price gap between the site and a legitimate marketplace, then there's reason to suspect a scam.

These account or transaction attributes constituted "moderate indicators" of fraud:

Smaller amounts broken down into multiple transactions with no observable community—e.g., five transactions, each under $10,000, spread over a few days—with no observable community. The bulletin warns to exercise caution "when looking at this indicator in isolation" because it might result from software testing.
Re-used code within the NFT. It is also important to note that it is common to share code in the software-development community, so this indicator alone is not definitive.
Minting an NFT, buying it at an inflated price, and selling for a considerable loss. For instance, a buyer acquires an NFT for $1M and sells it for $750K in a very short time. This might also be due to general volatility of the markets, so extra considerations would need to be made before coming to a conclusion.
No thumbnail on the marketplace profile. (Note, like the other indicators above, this indicator in isolation is not definitive.)
No checkmark for verification on market profile (Note, like the other indicators above, this indicator in isolation is not definitive): Verified accounts with a blue checkmark (OpenSea). However, legitimate accounts can be hacked by illicit actors who then use the accounts for their laundering/scams.
Non-existent contract address (Ethereum) for traceability on the project (Note: some legitimate projects have also exhibited this).
No clarity on when and where the NFT was minted.
Properties and project description fields of the NFT are empty or not clearly stated (Note: some legitimate projects have also exhibited this).
Significant number of sales in a collection purchased from same or clustered wallets

The J5 NFT Marketplace Red Flag bulletin makes it clear that no indicator by itself will definitively indicate fraud. To screen for potential fraud, individuals and institutions should take a comprehensive approach, not only looking out for the above-listed red flags but also implementing Know-Your-Client measures and other safeguards.

Canadian Income-Tax Implications for Canadian Taxpayers who Lose Cryptocurrency or Non-Fungible Tokens because of Fraud

A "disposition" of a "property" triggers a tax event for the Canadian taxpayer who disposed of that property. Canada's Income Tax Act gives a broad definition of the word "property," which includes intangible personal property, such as cryptocurrency and non-fungible tokens (NFTs).

The Income Tax Act's definition of "disposition" is also quite broad. Basically, a "disposition" occurs whenever a person relinquishes all aspects of property ownership (e.g., possession, control, etc.)—regardless of whether the person does so voluntarily or involuntarily, and regardless of whether the person receives compensation. Hence, each of the following transactions constitutes a "disposition":

The sale of a property;
A gift or donation;
The redemption or cancellation of a loan;
The expropriation or confiscation of a property;
Destruction of a property; and
Theft, loss, or abandonment of a property.

Therefore, if a taxpayer falls victim to fraud and loses cryptocurrency or non-fungible tokens, that taxpayer has thereby "disposed" of those digital assets. The disposition means that the taxpayer may realize the resulting loss for income-tax purposes. The taxpayer presumably received zero proceeds for the digital assets that were lost in the fraud. So, if the taxpayer's tax cost for those digital assets exceeds zero, the taxpayer can realize that amount as a loss for the year in which the fraud deprived the taxpayer of the digital assets.

Depending on the circumstances, the resulting loss is either a fully deductible business loss or a half-deductible capital loss. Canada's Income Tax Act sets out two entirely different tax regimes for business income, on the one hand, and for capital gains, on the other. In sum, if your digital-asset transactions attract income treatment, your cryptocurrency-trading or NFT-trading profits are fully taxable, and your cryptocurrency-trading or NFT-trading losses are fully deductible. If, on the other hand, your digital-asset transactions draw capital treatment, only one-half of your gains are taxable, and only one-half of your losses are deductible. Moreover, losses on income account are deductible against any source of income while losses on capital account may only offset capital gains.

A taxpayer's motive or intent at the time of acquiring the cryptocurrency or non-fungible token is the most important criterion that the Tax Court and the Canada Revenue Agency will consider when determining whether the transaction produced a capital gain or business income. Yet to discern a taxpayer's intention, the Tax Court and the CRA will focus on the objective factors surrounding both the purchase and the sale of the cryptocurrency.

For more information on distinguishing between capital gains and business income in the context of cryptocurrency transactions, please read our "Tax Guide for Crypto & Bitcoin Businesses: Computing Inventory Costs" and contact one of our top Canadian crypto-tax lawyers for a detailed tax opinion specifying how you should deduct your cryptocurrency fraud losses.

Expert Canadian Tax Guidance from a Canadian Crypto-Tax Lawyer: Voluntary Disclosures Program (VDP) for Unreported Cryptocurrency Income & Safeguarding Your Constitutional Rights

The Joint Chiefs of Global Tax Enforcement have identified over 50 leads concerning crypto-related tax crimes in each of the J5 countries, including Canada. The Canada Revenue Agency has already commenced tax-crime investigations.

This should definitely concern Canadian taxpayers with unreported profits from transactions involving cryptocurrency or non-fungible tokens. If you filed tax returns that omitted or underreported your cryptocurrency or NFT 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). But a voluntary-disclosure application is time-sensitive—especially so for the Canadian leads that are being pursued by the Joint Chiefs of Global Tax Enforcement. 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 starts investigating you about the non-compliance you sought to disclose.

To determine whether you qualify for the Voluntary Disclosures Program, schedule a confidential and privileged consultation with one of our expert Canadian crypto-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. Yet your communications with an accountant 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. Our experienced Canadian crypto-tax lawyers have helped numerous Canadian taxpayers bring their cryptocurrency and NFT dealings into compliance. 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.

When investigating suspected criminal offences—like cryptocurrency-related tax evasion—the Canada Revenue Agency must obtain a search warrant to gather evidence. The CRA cannot rely on its normal tax audit and information-gathering powers, such as those found in sections 231.1 and 231.2 of Canada's Income Tax Act and in sections 288 and 289 of Canada's Excise Tax Act. These sections permit the CRA's tax auditors to request and examine documents.

But the CRA can only use these powers during civil tax audits; it cannot use these powers when pursuing a criminal investigation for tax evasion. This is because, when the CRA's objective shifts from civil tax audit to criminal investigation, it triggers the protections granted by the Canadian Charter of Rights and Freedoms (Constitution Act, 1982). The Charter affords everyone in Canada with various protections when faced with criminal prosecution, including tax-fraud prosecution.

To ensure that the Canada Revenue Agency doesn't trample your constitutional rights, speak with one of our knowledgeable crypto-tax lawyers today. Our Certified Specialist in Taxation Canadian tax lawyer can recommend a course of action to determine whether the CRA has implicitly converted your civil tax audit into a criminal tax investigation. If so, we will take measures to safeguard your rights.

Frequently Asked Questions

Question: Over the past few years, I made a lot of money by trading various cryptocurrencies and non-fungible tokens. But I didn't report any of it on my Canadian income-tax returns. What can I do?

Answer: You might qualify for relief under the Canada Revenue Agency'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). For more information about qualifying for relief under the VDP, see our article on the CRA Voluntary Disclosures Program.

Question: I live in Canadian, and I've specifically used cryptocurrency and non-fungible tokens to conceal my income. It's possible that some of my cryptocurrency and NFT transactions might qualify as money laundering. I once believed that the Canada Revenue Agency couldn't possibly trace cryptocurrency and other blockchain transactions, but it seems that I was wrong. I want to avoid criminal prosecution by applying for relief under the Canada Revenue Agency's Voluntary Disclosures Program. Will I qualify for relief?

Answer: The Voluntary Disclosures Program will grant relief only if your VDP application satisfies various conditions. For example, 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 starts investigating you about the non-compliance you sought to disclose. Recently, an international coalition of tax administrators, known as the Joint Chiefs of Global Tax Enforcement, identified over 50 leads concerning crypto-related tax crimes in various countries, including Canada. So, your VDP application may be especially time sensitive. Don't delay! Schedule a confidential and privileged consultation with one of our expert Canadian tax lawyers today.

Canada: Tax Assistance