How We Saved a Bitcoin Multi-Millionaire from Criminal Prosecution for Tax Evasion

Case Overview: Resolving Crypto Currency Related Tax Delinquency under Canda Revenue Agency’s (CRA) Voluntary Disclosure Program (VDP)

Our client, a Canadian Taxpayer, began mining Bitcoin in 2017. In addition to mining, the Taxpayer also consistently purchased Bitcoin with Fiat. In 2017 when the Bitcoin network underwent two (2) hard forks, the Taxpayer received Bitcoin Cash (BCH) and Bitcoin Gold (BTG) worth hundreds of thousands of dollars. The Taxpayer promptly traded BCH and BTG for additional Bitcoin. Throughout the years, the Taxpayer also received cryptocurrency airdrops worth thousands of dollars. By the time the Taxpayer approached our expert Canadian Crypto Tax Lawyers for Crypto-Tax advice, the Taxpayer had amassed an untaxed Bitcoin portfolio worth over One Hundred Million Canadian Dollars ($100 Million).

The Problem: Legal Challenge for the Taxpayer

The Taxpayer failed to report millions of dollars in cryptocurrency-related income and holdings to the CRA. Part of the reason was that the CRA itself provided only sparse guidance to the general public about cryptocurrency transactions. Therefore, the Taxpayer had no idea (1) how to calculate cryptocurrency-related income; (2) whether to report this income as business income or capital gains; (3) whether the Bitcoin holdings should be reported on a T1135 forms; (4) how to report Bitcoin forks or cryptocurrency airdrops for Canadian tax purposes.

Our Approach: Voluntary Disclosure (VD) Application under CRA’s Voluntary Disclosure Program (VDP)

Despite needing to contend with several complicated crypto-tax issues, our top Canadian crypto-tax lawyers expertly and swiftly analyzed the Taxpayer’s cryptocurrency transactions, provided a tax-law opinion about the Canadian tax implications, and prepared and filed a VDP application on behalf of the Taxpayer – thereby saving the Taxpayer from civil tax liability in the form of gross-negligence penalties and from criminal tax liability for tax evasion.

Lessons Learned: Legal tax-law Challenges faced by our tax lawyers in preparing the VD application

1. The Characterization Issue: Is Bitcoin a Capital Property? Or is it inventory?

The characterization issue is one of the Canadian crypto-tax issues that our client’s situation raised. Canada’s Income Tax Act recognizes two broad sorts of property for tax purposes:

• Capital Property, which creates a capital gain or loss upon disposition; and
• Inventory, which figures into the computation of business income.

The type of income that the property generates upon sale – that is, capital gains or business income – determines whether the property is a capital property or inventory. In other words, you start by determining the nature of the income, and then you characterize the property, not the other way around. Hence, your profits from a transaction involving Bitcoin or any other cryptocurrency will be treated as either (a) business income or (b) a capital gain, and if they are characterized as business income, your cryptocurrency units constitute inventory.

The income/capital distinction also comes with important tax implications. Business income is fully taxable while only a portion of a capital gain is taxable. In particular, for the first $250,000, only one-half of the capital gain is taxable, and for any amount over $250,000, two-thirds of the capital gain is taxable.

Bitcoin and cryptocurrency transactions often straddle the line between income and capital. Canadian courts have turned out a large body of jurisprudence wrestling with the ambiguity between investing, which produces a capital gain or loss, and trading, which results in business income or expenses.

The taxpayer’s motive or intent at the time of acquiring the cryptocurrency is the most important criterion that courts consider when determining whether the transaction produced a capital gain or business income. Still to discern a taxpayer’s intention, the courts will focus on the objective factors surrounding both the purchase and the sale of the cryptocurrency. Applied to cryptocurrency transactions, these factors may include (a) transaction frequency (b) length of ownership (c) knowledge of cryptocurrency markets, etc.

In our extensive experience as Canadian crypto tax lawyers, most Canadian crypto investors and traders are not aware that this analysis exists, and they thereby report their crypto-related income, leaving themselves vulnerable to a CRA crypto-tax audit. To ensure that your tax returns are accurate, speak to one of our expert Canadian crypto-tax lawyers.

2. Canadian Tax Implications of Bitcoin Mining

Our client had also spent several years mining Bitcoin. Cryptocurrency mining can match at least three distinct tax characterizations, each of which comes with its own set of Canadian tax implications. Moreover, the mining itself and the disposition of the cryptocurrency acquired through mining are two separate activities, and they each invoke different Canadian crypto tax rules.

2.1 Crypto mining as a hobby

A taxpayer might engage in cryptocurrency mining purely as a hobby without any commercial intent. (Granted, crypto mining as a hobby is far less likely nowadays because of its prohibitive costs.) Hobby mining doesn’t qualify as a “source of income” for Canadian tax purposes. Therefore, when a hobbyist miner obtains cryptocurrency through mining, the miner need not report the value of those mined crypto units as income. Instead, the income inclusion (or loss realization) happens when the taxpayer disposes of the mined crypto units.

2.2 Cryptocurrency mining as akin to acquiring inventory

A second alternative views cryptocurrency mining as akin to acquiring inventory – namely, the inventory in a cryptocurrency trading business. Just as a gold miner doesn’t recognize an income inclusion upon unearthing gold deposits, a cryptocurrency trader doesn’t recognize taxable income when acquiring cryptocurrency through mining. Instead, the income inclusion (or loss realization) occurs when the cryptocurrency trader disposes of the mined crypto units.

2.3 Cryptocurrency mining as akin to providing a service

A third alternative treats cryptocurrency mining as akin to providing a service. Through cryptocurrency mining, the taxpayer expends computing power to validate blockchain transactions and thereby provides a service to users collectively. In exchange, the cryptocurrency miner receives compensation in the form of a mining reward. Under this interpretation, cryptocurrency mining is itself a source of income which is fully taxable under subsection 9(1) of Canada’s Income Tax Act.

3. Canadian Income Tax Implications of Receiving New Cryptocurrency under a Hard Fork / Chain Split: Tax-Free Windfall or Income from a Source?

In 2017, when the Bitcoin network underwent two hard forks, our client received Bitcoin Cash and Bitcoin Gold worth hundreds of thousands of dollars. This raised the questions about our client’s Canadian tax obligations with respect to receiving those forked coins.

Two Canadian tax principles bear on the tax-law analysis of the Bitcoin hard forks. The first principle is that a receipt is taxable only if it’s “income from a source”. This is why the winnings of an amateur gambler isn’t taxed.

The second tax principle relates to characterizing the income stemming from a property or asset. Depending on how it’s used, a property can generate business income, investment income, or capital gain.

The first principle raises the question of whether the receipt of forked coins constitutes a source of income. The second principle affects those Canadian taxpayers for whom the receipt of forked coins was indeed a source of income. For them, the issue is how to properly report that income.

4. Canadian Income-Tax Implications of Receiving & Disposing of Cryptocurrency Airdrops

Our expert Canadian crypto-tax lawyers were also required to analyze the Canadian tax treatment of our client’s cryptocurrency airdrops. Our client’s cryptocurrency airdrops gave rise to a similar tax-law analysis as that invoked by our client’s Bitcoin hard forks. Receiving airdrops tokens doesn’t usually count as a source of income unless the airdrop relates to a business run by the recipient, and it is possible that these airdrops may be considered as a tax-free windfall depending on the case specific situation.

5. The T1135 – Filing Requirement under Section 233.3 of the Income Tax Act: Is Bitcoin a “Specified Foreign Property”?

Our client’s massive Bitcoin holdings also required our Canadian Certified Tax Specialist Lawyer to determine whether our client had an obligation to file T1135 forms to report specified foreign property. If so, then our client’s VD application would need to include T1135 forms otherwise, our client faced steep penalties if he had to file T1135 forms when required to do so.

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 article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.