David Rotfleisch on How the FBI Used NexFundAI, a Cryptocurrency, to Reel in "Pump-and-Dump" Market Manipulators

In October, the FBI revealed that it had created a cryptocurrency called NexFundAI as part of an investigation into price manipulation in the crypto markets. This Ethereum-based token was developed with the help of “cooperating witnesses.” As a result of the investigation, the Securities and Exchange Commission filed charges against three “market makers” and nine individuals for allegedly manipulating cryptocurrency prices. Simultaneously, the Department of Justice indicted 18 individuals and entities for what it described as “widespread fraud and manipulation” in the crypto markets.

Prosecutors claim the accused misled investors about their tokens and carried out “wash trades” to artificially boost trading activity. The three market makers—CLS Global, ZMQuant, and MyTrade—allegedly participated in or conspired to execute wash trading schemes involving NexFundAI, unaware that the FBI had created the token.

According to legal filings, the defendants behind various cryptocurrency ventures are accused of making false claims about their tokens and orchestrating fraudulent trades to inflate market activity artificially. Prosecutors allege that firms were paid to execute these wash trades, creating the illusion of strong investor interest and driving up token prices. Once the prices were artificially inflated, the defendants allegedly cashed out their holdings in a classic “pump-and-dump” scheme. Among the implicated entities, Saitama stood out as one of the largest, at one point reaching a market valuation in the billions.

How do these fraudulent schemes operate? Terms like “wash transactions” and “pump and dump” are often associated with financial fraud. In this article, we’ll break down how scammers use these deceptive tactics to manipulate markets, rake in millions, and exploit unsuspecting investors.

Artificially Inflating Market Activity Through Wash Transactions

A crypto wash transaction, or wash trading, occurs when an investor or a coordinated group deliberately buys and sells the same cryptocurrency among themselves to generate false trading activity and artificially inflate market volume.

This tactic is intended to create the illusion of strong market interest and liquidity in a cryptocurrency, misleading potential investors into believing there is genuine demand. By inflating trading volume, wash trading can manipulate price indicators, potentially activating automated trading algorithms or enticing other traders to invest. As more investors buy in, the artificially boosted demand can further drive up the price.

Once the price is artificially driven up through fabricated trading activity,  the perpetrators offload their holdings at a premium before the market adjusts—a tactic known as a “pump and dump” scheme. Wash trading is illegal in many jurisdictions because it deceives investors by creating the illusion of real market demand without an actual exchange of ownership. This practice is particularly concerning in cryptocurrency markets, where there is less regulatory oversight and greater anonymity in terms of who is buying and selling, making it easier for fraudsters to manipulate prices and mislead investors.

Manipulating Markets Through Pump-and-Dump Schemes

A “pump and dump” scheme is a type of securities fraud in which the price of a stock or cryptocurrency is artificially inflated (the “pump”) before the perpetrators sell off their holdings at the inflated price (the “dump”).

To execute this scheme, fraudsters aggressively promote the asset through social media, newsletters, or chat rooms, often using paid advertisements or spreading misleading information about its future potential, upcoming developments, or supposed partnerships. This hype is designed to lure unsuspecting investors into buying the asset, driving its price higher.

In many instances, certain individuals or insiders gain early access to the asset at presale prices, allowing them to purchase the cryptocurrency at its lowest value. These individuals often hold a significant share of the total available tokens, meaning their trading activity can heavily influence the market price. Known as “whales,” they may claim they won’t sell their holdings until a specified time, but such assurances are often misleading. Investors should be cautious, as these promises frequently turn out to be false.

Next, the coin is made available to the public, attracting buyers who drive up its price. As demand surges due to the hype, the original promoters and insiders—who hold large quantities of the asset—sell off their holdings at the peak price. This sudden sell-off triggers a sharp decline, as the demand was artificially generated rather than stemming from genuine market interest. As a result, those who purchased the coin at inflated prices are left with devalued assets, while the early insiders walk away with significant profits, often leaving the coin’s value near zero.

This scheme preys on investors’ Fear of Missing Out (FOMO), compelling them to buy the asset at inflated prices in hopes of catching the next big opportunity. However, once the whales and insiders offload their holdings, the price plummets, leaving latecomers with worthless assets. These schemes overwhelmingly benefit the early insiders, as their ability to sell at peak prices directly causes the drastic market collapse that follows.

Investors who buy in during the “pump” phase often face substantial financial losses when the price crashes. Pump-and-dump schemes are illegal in many countries as they rely on market manipulation and deception. Regulatory bodies such as the SEC in the U.S. and the OSC in Ontario actively investigate and prosecute those involved, particularly in less transparent markets like cryptocurrency, where these fraudulent tactics are increasingly common.

Tax Treatment of Crypto Pump-and-Dump Losses in Canada

In Canada, investors may be able to claim losses from cryptocurrency pump-and-dump schemes as capital losses for tax purposes, provided certain conditions are met. To qualify, the cryptocurrency must be disposed of, meaning the investor must sell, trade, or otherwise realize the loss before it can be claimed.

In a pump-and-dump scenario where the asset’s value drops to nearly zero, investors may still hold the token, resulting in an unrealized loss. To claim this loss for tax purposes, the investor must first realize it by disposing of the token—this could involve selling it for its minimal remaining value or trading it for another cryptocurrency.

The capital loss can be applied to offset capital gains in the current year, with any unused portion eligible to be carried back three years or forward indefinitely to offset future capital gains. However, if the crypto activity is classified as business income rather than capital gains, the tax treatment may differ, potentially allowing for a full deduction against business income. Determining whether a loss falls under capital or business income requires a fact-specific analysis, and consulting an experienced Canadian crypto tax lawyer may be necessary for proper classification.

Canadian courts have identified several factors to determine whether income from cryptocurrency transactions is classified as capital gains or business income. These factors include:

• •Intent at acquisition – The taxpayer’s purpose when purchasing the asset is the most significant factor.
• •Holding period – A short duration of ownership generally suggests a trading motive, indicating business income.
• •Transaction frequency – Frequent buying and selling of cryptocurrency typically points to business income.
• •Expertise – Advanced knowledge of crypto markets may suggest business income.
• •Time investment – Significant time spent researching and managing crypto investments often aligns with business income.
• •Financing – Using borrowed funds to invest in crypto usually indicates business income.
• •Public promotion – If a taxpayer publicly represents themselves as a crypto trader or expert, it may be considered business income.

While intention is the primary factor in determining whether crypto income is classified as capital gains or business income, the CRA may find it challenging to prove a taxpayer’s intent at the time of acquisition. In such cases, they may analyze the length of ownership and transaction frequency to infer intent, along with other relevant factors. Frequent trading increases the risk of the CRA recharacterizing crypto dispositions as business income. If you’re uncertain about how to classify your crypto income, consulting a top Canadian crypto tax lawyer is highly recommended.

Tax Pro Tip: Keep Records of All Speculative Crypto Transactions

Keeping thorough records of all crypto transactions is essential, especially in cases involving pump-and-dump schemes. Proper documentation can serve as crucial evidence that your transactions were legitimate and not part of any fraudulent activity. Additionally, if you incur a loss, having detailed records may support a claim for a capital loss. At a minimum, you should document the following for each crypto transaction:

• •The date of acquisition and sale
• •The type of cryptocurrency sold and what was received in exchange
• •The adjusted cost base (ACB) of the asset
• •The sale price
• •The resulting profit or loss

Frequently Asked Questions (FAQs)

What if I unknowingly participated in a pump-and-dump scheme in Canada?

If you can demonstrate that you unknowingly participated in a pump-and-dump scheme, your crypto transactions would likely be treated the same as any other for tax purposes, whether resulting in gains or losses. However, involvement in such a scheme—intentional or not—may draw scrutiny from the CRA. Keeping detailed records is essential to support your tax position. Consulting a knowledgeable Canadian tax specialist is highly recommended if you face a CRA audit related to a crypto pump-and-dump scheme.

How can I identify a crypto pump-and-dump scheme?

• •A sudden surge in activity without any legitimate news or development.
• •Claims of guaranteed high returns or “insider tips” from unknown or unverified sources.
• •The cryptocurrency’s price skyrockets without any solid reason, such as technological advancements or major partnerships.
• •Intense discussions urging people to buy a specific coin on platforms like Telegram, Discord, or Twitter. Many of these promoters are either paid by insiders or given presale tokens, which they later sell as part of the “dump” phase.

While some traders attempt to profit by buying early and selling before the dump, this approach is extremely speculative and risky. In most cases, only a small group—typically those orchestrating the pump—reap the rewards, while the majority of investors who buy in at the peak suffer substantial losses.

Ultimately, protecting yourself from a pump-and-dump scheme is in your hands. Before investing in a newly launched cryptocurrency, conduct thorough research and only invest what you can afford to lose. These investments carry significant risks, and if an opportunity seems too good to be true, it likely is.

I invested in a cryptocurrency, and its value dropped to zero. How is this treated for Canadian income tax purposes?

To claim this loss for tax purposes, you must dispose of the token—either by selling it for its remaining minimal value or trading it for another cryptocurrency. The resulting capital loss can then offset capital gains in the current year, and any unused portion may be carried back three years or forward indefinitely to reduce future capital gains.

If the crypto activity is classified as business income rather than capital gains, the tax treatment may differ, potentially allowing for a full deduction against business income. Determining whether a loss falls under a business or capital account requires a detailed legal analysis, as it depends on various factors and is not always clear-cut. Consulting an expert Canadian crypto tax lawyer can help ensure proper classification and compliance.

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DISCLAIMER: “This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.”

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