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.
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.