Introduction - The IRS Amps Up Efforts to Collect Taxpayer Information from Cryptocurrency Exchanges
On April 1, 2021, a federal court in the District of Massachusetts allowed the United States Internal Revenue Service to serve a John Doe summons on the Boston-based cryptocurrency exchange, Circle Internet Financial Inc. and on its spinout company, Poloniex LLC.
An IRS John Doe summons requires a third party-in this case, Circle Internet Financial and Poloniex-to provide the IRS with information about unnamed, unknown taxpayers with potential tax liability. Specifically, the Internal Revenue Service wants Circle and Poloniex to identify all US-based clients who executed at least $20,000 in cryptocurrency transactions from 2016 to 2020. Circle and Poloniex must also surrender the cryptocurrency-transaction records for each affected taxpayer.
This isn't a one-off. In 2017, the IRS obtained a similar court order requiring the virtual-currency exchange, Coinbase, to surrender information about users with at least $20,000 in cryptocurrency transactions from 2013 to 2015. And on March 30, 2021-only two days before the federal court approved the John Doe summons for Circle and Poloniex-the Internal Revenue Service sought a John Doe summons for the San Francisco-based cryptocurrency exchange, Kraken. Again, the IRS sought information about any Kraken cryptocurrency-account holder with at least $20,000 in cryptocurrency transactions during the period from January 1, 2016, to December 31, 2020. The Internal Revenue Service will likely invoke the John Doe summons with greater frequency as it continues efforts to identify non-compliant cryptocurrency users through tax investigations that begin with cryptocurrency exchanges.
How an IRS John Doe Summons Allows the Canada Revenue Agency to Gain Information about Canadian Cryptocurrency Investors & Traders
These IRS tax investigations should alarm Canadian taxpayers who used US-based cryptocurrency exchanges and failed to report cryptocurrency profits or holdings on their Canadian income-tax returns. In the summer of 2018, an international coalition of tax administrators-including the Canada Revenue Agency and the United States Internal Revenue Service-promised to pool their resources and expose cryptocurrency users who dodged their tax obligations. The project seeks to uncover unreported income and assets stemming 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 Diem (formerly called Libra). Moreover, the CRA and the IRS mutually exchange taxpayer information by virtue of their participation in 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 domestic tax laws.
As a result, after prying records from US-based cryptocurrency exchanges, the Internal Revenue Service will likely share its findings with the CRA, thereby allowing the Canada Revenue Agency to identify, audit, and prosecute Canadian cryptocurrency traders and investors who attempted to dodge Canadian tax obligations by using US-based cryptocurrency exchanges.
Indeed, this flow of information very likely allowed the Canada Revenue Agency to target some Canadian taxpayers during previous cryptocurrency-audit campaigns. In 2019, for instance, many Canadian cryptocurrency traders and investors were shocked to receive a 13-page CRA questionnaire about their cryptocurrency transactions.
Moreover, the Internal Revenue Service's approach parallels the approach taken by Canada Revenue Agency to identify Canadian cryptocurrency users who failed to comply with tax obligations. On March 19, 2021, the CRA obtained a Federal Court order requiring the Canadian cryptocurrency exchange Coinsquare to identify all Canadian customers that held cryptocurrency accounts with a value of $20,000 or more during the period from 2014 to 2020 or that held cryptocurrency accounts with total deposits over $20,000 since the account's creation. Coinsquare must also list its 16,500 largest Canadian cryptocurrency-account holders by trading volume, and Coinsquare must release the cryptocurrency-transaction records for each affected taxpayer. The CRA's treatment of Coinsquare mirrors the IRS's blitz on the US-based cryptocurrency exchanges Circle Internet Financial, Poloniex, Coinbase, and Kraken.
The CRA's Cryptocurrency Tax-Audit Questionnaire
The CRA typically begins a cryptocurrency 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 cryptocurrency-audit questionnaire, which includes over 50 questions on a range of topics, such as:
- The timeline of owing or using cryptocurrency;
- The types of cryptocurrencies purchased or sold-e.g., Bitcoin (BTC), Bitcoin Cash (BHC), Litecoin (LTC), Ethereum (ETH), Chainlink (LINK), Dash, Zcash (ZEC), Ripple (XRP), Monero (XRM), Zcash (ZEC), Dash (DASH), Grin (GRIN), Komodo (KMD), Verge (XVG), Plasma, OmiseGo, etc.;
- 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 generated passive income for the taxpayer (e.g., blockchain or cryptocurrency liquidity mining and yield farming);
- 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.
Expert Canadian Tax Guidance from a Canadian Tax Lawyer: Record-Keeping, Legal Opinion on Proper Cryptocurrency Tax Reporting & Cryptocurrency Tax Planning, Voluntary Disclosures Program for Unreported Cryptocurrency Income & Solicitor-Client Privilege
A taxpayer who lacks proper records will be at the CRA's mercy during a cryptocurrency tax audit. Cryptocurrency traders and investors should maintain records of all their cryptocurrency transactions. The same is true for any business that accepts cryptocurrency as payment for goods and services. In particular, you should 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.
If you use a cryptocurrency exchange, you should periodically export your transaction information to avoid losing it. Many taxpayers lost all their cryptocurrency-transaction records when the Canadian cryptocurrency-exchange QuadrigaCX when bankrupt and turned out to be nothing more than a Ponzi scheme.
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.
A Canadian-controlled private corporation (CCPC) enjoys a reduced tax rate on its first $500,000 of active business income, and its individual shareholders can defer shareholder-level tax to the extent that retained earnings stay within the corporation. So, you may benefit from incorporating your cryptocurrency portfolio if you operate a cryptocurrency-trading business and thereby earn fully taxable business income (as opposed to half taxable capital gains). For advice on cryptocurrency tax-planning involving incorporation, contact one of our knowledgeable Canadian tax lawyers today.
The cooperative efforts of tax authorities signal the end of the anonymity that was once associated with cryptocurrency investing and trading. 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 assisted many Canadian taxpayers with correcting non-compliance involving cryptocurrency. We can carefully plan and promptly prepare your voluntary-disclosure application. A properly prepared disclosure application not only increases the odds that the Voluntary Disclosures Program 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. Solicitor-client privilege prevents the Canada Revenue Agency 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 first approach a Canadian tax lawyer. If an accountant is needed, your Canadian tax lawyer can retain the accountant on your behalf and extend legal 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.