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David Rotfleisch’s Primer on How to Handle a Cryptocurrency Tax Audit: A Canadian Tax Lawyer’s Advice, Tips

posted 12 months ago

The Canada Revenue Agency (CRA) is becoming more meticulous when reviewing cryptocurrency tax returns.

Monitoring cryptocurrency dealers has become increasingly important to tax authorities and regulatory bodies around the world in recent years. Notably, the Canada Revenue Agency (CRA) and the Internal Revenue Service (IRS) in the United States have adopted active initiatives to solve this issue. Identifying taxpayers during a tax audit focusing on cryptocurrency activities in Canada is difficult due to the anonymous nature of cryptocurrency transactions, which is a big challenge for Canadian cryptocurrency tax agencies.

In order to gather data on all US users of Coinbase who had transacted in Bitcoin between 2013 and 2015, the Internal Revenue Service (IRS) filed a broad summons in 2016. This summons became known as the “John Doe” summons. As predicted, the Federal Court of Canada approved an order in March 2021 enabling the Canada Revenue Agency (CRA) to ask Coinsquare Ltd., the biggest cryptocurrency exchange in Canada, for particular information about cryptocurrency dealers.

Despite first refusing the order, Coinsquare and the CRA ultimately came to an agreement whereby Coinsquare will supply the CRA with specific user data going back to 2014. With access to this data and the shared taxpayer data from the IRS, the CRA is likely to be able to identify anyone who failed to accurately disclose their cryptocurrency transactions. As a result, more cryptocurrency tax audits are anticipated.

Frequently asked CRA cryptocurrency audit queries

Recently, the Canada Revenue Agency (CRA) began the task of conducting cryptocurrency tax audits for anyone who engages in Bitcoin transactions. Taxpayers will receive full questionnaires for this audit that are 13 pages long and contain 54 questions. These inquiries deal with a variety of topics, including investments, past mining operations, possessions, wallets, and other pertinent issues. The following are a few illustrations of the kinds of inquiries found in the CRA’s crypto tax audit questionnaire:

  • When did you initially begin participating in the Bitcoin industry, and what prompted you to get involved?
  • Are you currently involved in mining or investing in cryptocurrencies? Do you have any additional responsibilities or activities in the cryptocurrency industry, such as consulting, teaching, running a bitcoin ATM service, selling hash power, managing an exchange, joining a mining pool, or engaging in any other business endeavors?
  • Have you experienced any cryptocurrency tumblers or mixing services? If so, kindly give more information about the specific services you have utilized. Please also send us a list of all the cryptocurrency addresses you used for mixing, as well as the tracing history. Could you also provide some background on why you utilize these services?
  • Have you ever exchanged cryptocurrencies using a site like Shapeshift or Changelly? If yes, kindly give us the dates on which these “swap” deals were executed as well as the bitcoin addresses linked to your transactions.
  • Can you give a brief description of every cryptocurrency you now own? Also, send us a timeline detailing the dates of each purchase you made when changing fiat money to

Taxation of cryptocurrency gains

Depending on the specifics of each situation, the tax treatment of income from cryptocurrency transactions, such as cryptocurrency trading or cryptocurrency mining, can vary. The treatment of these gains for taxation purposes is based on a number of variables.

Gains for those who trade cryptocurrencies can be classified as either business income or capital gains. The decision is generally based on the parties’ intention at the time of the transactions, and it is influenced by the following elements as described in the Happy Valley Farms case:

  • Transaction frequency: The volume of trades made.
  • Time spent holding: The amount of time spent holding bitcoins before selling them.
  • Securities’ nature and amount: The kind and number of cryptocurrencies used in the trading activity.
  • Intention to purchase securities for profit: Whether the individual’s goal was to purchase and resell cryptocurrencies in order to turn a profit.
  • Time invested on the activity: The time allotted to trading cryptocurrencies.

There are normally two possible classifications for mining cryptocurrencies: personal hobby and commercial activity. According to case law, an activity must comply to accepted standards of businesslike behavior and the taxpayer’s primary goal must be to create a profit in order for it to be classified as a business. If the personal components of the activity dominate the commercial components, it is typically categorized as a hobby rather than a business.

Pro Tax Advice: How to get ready for a cryptocurrency tax audit

To ensure you have accurate information about your activities, a trader or investor in cryptocurrency should keep records of all purchases, sales, and mining. When conducting a cryptocurrency tax audit, the CRA will have the whims of any taxpayer who does not maintain accurate financial cryptocurrency records. Consequently, a taxpayer should typically keep the records of the following cryptocurrency transactions, without being limited to them:

  • Observe the specifics of the transaction: Each bitcoin transaction, including purchases, sales, and mining operations, should be noted down along with the date. Record the bitcoin addresses involved as well as the distinct transaction IDs for each transaction.
  • Keep your receipts from purchases: Save your receipts from any bitcoin transactions or transfers. The amount, date, and cryptocurrency’s value in Canadian dollars at the time of the transaction should all be listed on these receipts.
  • Details of document transactions: Give a detailed account of each transaction, mentioning the counterparty (and any relevant details, such as their cryptocurrency address), as well as the transaction’s goal. This makes it clearer what your cryptocurrency actions are and what they’re intended to accomplish.
  • Keep track of your wallet and exchange transactions: Keep track of all of your purchasing, selling, and trading activity on cryptocurrency exchanges. Keep track of the addresses and balances of your wallet as well.
  • Keep cost records on file: Observe all accounting and legal expenses connected to your cryptocurrency-related activity. Also, keep track of any software costs you incur specifically for handling your tax obligations.

It is crucial for miners to keep thorough records in order to make sure proper preparedness for a cryptocurrency tax audit. Cryptocurrency miners also should preserve the following precise records:

  • Receipts for Mining Hardware: As proof of your investment in the machinery, keep the receipts from any purchases you make of mining hardware for cryptocurrencies.
  • Documentation of Expenses: Save all receipts and supporting materials for any costs related to your mining business. Costs for electricity, internet access, mining software, upkeep, and repairs are included.
  • Mining Pool Agreements and Records: Keep copies of all mining pool agreements, as well as any documents or agreements pertaining to the distribution of mining rewards.
  • Record of Mining Activities: Keep any additional records that are pertinent to your mining operations, including as mining logs, hashrate information, and information on the currencies you have mined.
  • Disposition of Mined Cryptocurrency: Keep track of every transactions in which you dispose of cryptocurrency that you have acquired through mining. Dates, sums, costs associated with transactions, and fair market value of the coins at the time of disposal are all included.

But a taxpayer is not compelled to respond to every query a CRA crypto tax auditor puts to them. In MNR v. Cameco Corporation, 2019 FCA 67, the Federal Court of Appeal upheld the lower court’s ruling that the CRA lacked the authority to compel a taxpayer to provide information during the tax audit stage. However, a taxpayer must be aware that the CRA may reach an unfavorable conclusion and suggest additional fines if they decide not to provide information during a bitcoin tax audit. It is never advisable for a taxpayer to communicate with the CRA directly, and it is strongly advised that they contact a knowledgeable Canadian crypto tax lawyer to help them prepare their answers to the CRA’s audit questionnaires and communicate with the agency. If an accountant is required, a Canadian tax lawyer may then appoint the accountant on the taxpayer’s behalf and extend the solicitor-client privilege.

FAQ:

Frequently Asked Question:

Question: Is it required for a taxpayer to respond to all of the auditor’s inquiries regarding crypto taxes?

Answer: At the initial tax audit stage, the CRA is not permitted to demand that taxpayers provide answers. But if a taxpayer declines to respond to specific audit inquiries, the CRA may infer something adverse and suggest additional fines. Thus, keeping accurate financial records and contacting a knowledgeable Canadian cryptocurrency tax lawyer to help you with the process are the best ways to get ready for a bitcoin tax audit.

Question: What does the voluntary disclosure program entail? How does it help the taxpayer?

Answer: For taxpayers who filed prior tax returns with errors or who neglected to disclose their income, a voluntary disclosure application is designed to help them admit to their errors and make the necessary corrections. For the voluntary disclosure program to be available to a taxpayer, they must fulfill the five requirements. If accepted, there are some circumstances where the taxpayer may be free from fines and obtain some interest relief.

Question: I’m currently the target of a crypto tax audit. What are the potential results?

Answer: Tax assessments or reassessments with higher tax burdens may result from a crypto tax audit. When the CRA suspects someone has made or assisted in creating a false statement or omission in a return, whether intentionally or due to circumstances that constitute gross negligence, they nearly invariably levy a gross negligence penalty with a 50% additional tax. A criminal inquiry that could result in a tax prosecution for tax evasion will likely be launched by the CRA if it determines that a taxpayer has engaged in it by fabricating records and claims.

Disclaimer:

“This article contains generic information that may or may not be up to date because it was not recently updated. As a result, it may no longer be applicable or useful. This post does not give legal advice and should not be construed as such. Each tax situation is unique, and the precise facts of your case may differ from those presented in this article. If you have specific legal problems or concerns, it is recommended that you consult with a knowledgeable lawyer for tailored guidance”.

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