Canadian Cryptocurrency Tax Trap: Poor Record-Keeping Will Leave You At The CRA’s Mercy: Record-Keeping Requirements For Canadian Cryptocurrency Traders & Investors – Canadian Tax Guidance From A Canadian Tax Lawyer – Tax

Introduction – The CRA Targets Taxpayers Who Keep Poor
Records

The Canada Revenue Agency isn’t shy about pursuing a tax
audit. But the CRA invokes its most aggressive tactics when
auditing groups that CRA tax auditors perceive as most likely to
retain poor records or lack internal controls-groups such as those
who use, trade, and invest in cryptocurrency. Canadian cryptocurrency users
are often shocked when they receive the CRA’s 13-page tax-audit
questionnaire about their transactions involving cryptocurrency
such as Bitcoin (BTC), Bitcoin Cash (BHC), Litecoin (LTC), Ethereum
(ETH), Chainlink (LINK), Dash, Zcash (ZEC), and Ripple (XRP). In
addition, Canada’s Income Tax Act requires all
Canadian taxpayers-including Canadian cryptocurrency users-to
maintain adequate books and records.

This article examines the record-keeping requirements for
Canadian cryptocurrency traders and investors. After reviewing the
Income Tax Act‘s record-keeping requirements and the
CRA’s tax-audit powers, this article identifies the specific
records that cryptocurrency users should maintain. It concludes by
offering pro tax tips from our top Canadian crypto-tax lawyers for
Canadian cryptocurrency traders and investors.

Tax Record-Keeping Requirements: Section 230 of Canada’s
Income Tax Act

Section 230 of Canada’s Income Tax Act effectively
requires every Canadian taxpayer to maintain adequate books and
records. The record-keeping requirement applies to every person who
carries on a business or who is required to pay income tax or
collect income tax (or pay or collect any other amount, such as
interest, penalties, or vicarious tax liability under section 160
of the Income Tax Act). The books and records must suffice
to enable one to determine the amount of income tax payable (or to
determine any amount that should have been deducted, withheld, or
collected). The taxpayer must keep these records at a residence or
place of business in Canada.

Section 230 also imposes a general six-year retention period.
That is, a taxpayer must retain books, records, and supporting
documents for at least six years after the end of the last tax year
to which those documents relate. In practice, this rule means that
you must typically retain records for considerably longer than six
years. For example, suppose that you purchased various
cryptocurrency units in 2016 and sold them in 2022. Your 2016
records concerning the cryptocurrency purchase will relate to the
2022 taxation year in which you made the sale. So, you must retain
the 2016 purchase records for at least the six years following
2022-that is, until at least 2028!

The failure to maintain records is a summary-conviction criminal
offence under section 238 of the Income Tax Act. Anyone
who fails to comply with the above-mentioned record-keeping
requirements may face a minimum fine of $1,000 (up to a maximum of
$25,000), plus up to 12 months’ imprisonment. In addition, the
Canada Revenue Agency may levy gross-negligence penalties. Our
experienced Canadian litigation tax lawyers can assist you if you
have been charged with an Income Tax Act offence.

The CRA’s Income-Tax Audit Powers & Cryptocurrency
Tax-Audit Questionnaire

Of course, Canada’s Income Tax Act not only
requires you to maintain records but also entitles the CRA to
examine those records. Sections 231.1 and 231.2 of Canada’s
Income Tax Act govern the Canada Revenue Agency’s tax
audit and information-gathering powers. These rules empower the
CRA’s income-tax auditors to:

• inspect, audit, or examine any document belonging to a taxpayer
  or to any other person;




• examine the property belonging to a taxpayer or to any other
  person;




• enter any premises to examine documents or property; and




• require any person-including banks and accountants-to provide
  any information or document.

These tax-audit rules also allow the CRA to issue a requirement
for information, which is essentially a letter demanding that a
taxpayer (or any relevant third party-including accountants, since
they don’t have legal privilege) release specified documents or
information. If the taxpayer refuses, the Canada Revenue Agency
can, under section 231.7 of the Income Tax Act, pursue a
court order forcing the taxpayer’s compliance.

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 the cryptocurrency tax-audit
questionnaire.

The Canada Revenue Agency’s cryptocurrency tax-audit
questionnaire 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, Tether (USDT), etc.;




• The use of third-party exchange wallets (e.g., Coinbase,
  Binance, etc.);




• 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, proof-of-stake mining, etc.);




• Participation in cryptocurrency proof-of-stake validation
  (staking or forging) or cryptocurrency proof-of-work validation
  (mining), including questions about the sort of proof-of-work
  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 to verify the taxpayer’s answers
to the cryptocurrency tax-audit questionnaire.

Record-Keeping Practices for Canadian Cryptocurrency Traders
& Investors

Canadian cryptocurrency users who lack proper records will be at
the CRA’s mercy during a cryptocurrency tax audit. For example, when a
taxpayer’s dismal record-keeping precludes a Canada Revenue
Agency tax auditor from using the standard (generally, more
reliable) tax-audit techniques, the tax auditor will employ an
indirect method of income verification. The tax auditor may, for
instance, compare your household budget and expenditures with data
collected by Statistics Canada, or review the deposits appearing on
your bank-account statements, or estimate the growth of your net
worth over a specified period.

The problem is that indirect-income-verification methods
don’t give accurate results, and, when used by a CRA tax
auditor, these methods typically lead to wildly inflated income-tax
assessments. The Canada Revenue Agency’s advantage lies in the
fact that, under Canada’s income-tax system, the taxpayer has
the initial onus of rebutting the CRA’s assumptions. In other
words, a cryptocurrency user’s lack of records will ultimately
benefit the Canada Revenue Agency. Without adequate record-keeping,
a cryptocurrency trader or investor will find it difficult to rebut
the CRA’s indirect-income-verification methods unless the
cryptocurrency user seeks assistance from a knowledgeable Canadian
crypto-tax lawyer, who can poke holes in the tax auditor’s
analysis, thereby forcing the CRA to adopt a more reasonable
method-a method based, for instance, on a blockchain-forensics
analysis.

Hence, 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;




• The transaction ID (i.e., TxID or Tx Hash);




• 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 (e.g., mining-pool
  contracts).

If you use a cryptocurrency exchange, you should periodically
export your transaction information to avoid losing it. Ideally,
you should also use offsite or cloud storage to back up your
documents and computer files. Many Canadians lost all their
cryptocurrency-transaction records when the Canadian
cryptocurrency-exchange QuadrigaCX went bankrupt and turned out to
be nothing more than a Ponzi scheme.

You should also maintain a copy of any formal legal opinions
that you received from your top Canadian crypto-tax lawyer. For
instance, our expert Canadian crypto-tax lawyers can prepare a tax
memorandum examining whether your cryptocurrency profits should be
reported as capital gains, as business income, or as a blend of
both. This confidential and privileged document can prove
invaluable by ensuring that the CRA doesn’t fault you for
misrepresenting the information in your tax returns.

Pro Tax Tips: Protecting Your Rights During a Cryptocurrency
Tax Audit

The CRA’s tax auditors enjoy significant
information-gathering powers. And courts respect these powers. As a
result, if you’re the subject of a CRA cryptocurrency tax
audit, you won’t find much legal support for simply ignoring
the tax auditor’s requests for information.

That said, you need not answer every question posed by a CRA tax
auditor. The Federal Court of Appeal confirms that the Canada
Revenue Agency “does not have the power to compel a taxpayer
to answer questions at the audit stage”: MNR v Cameco
Corporation, 2019 FCA 67, at para 28. (The 2021 federal budget
proposed to override the Cameco decision by amending
section 231.1 of Canada’s Income Tax Act. The proposal
would have allowed the Canada Revenue Agency to compel a taxpayer
to answer questions “orally or in writing, in any form
specified by the [CRA tax auditor].” But this proposed
amendment was ultimately cut from the final draft of Bill C-30, the
Budget Implementation Act, 2021, No. 1., which received
royal assent and became law on June 29, 2021. So, at the moment,
the Cameco decision still stands.)

Yet while you need not answer a CRA tax auditor’s questions
during a cryptocurrency tax audit, you should understand that the
tax auditor may draw an unfavourable inference when you refuse to
answer questions. The CRA is also free to make assumptions and to
assess tax on the basis of those assumptions. Moreover, during a
Tax Court appeal, the knowledgeable Canadian litigation tax lawyer
for the taxpayer bears the onus of rebutting any assumptions made
by a CRA tax auditor. In other words, whether you face a
cryptocurrency tax audit or any other form of tax audit, you must
pick your battles. Otherwise, you may find yourself facing a slew
of outlandish assumptions.

Fortunately, Canadian cryptocurrency users can generally avoid
these problems through early engagement of an experienced Canadian
crypto-tax lawyer, who can advise you of your rights, determine
when it may actually help your case to answer a tax auditor’s
questions, prepare you or other potential witnesses for the tax
auditor’s questions, and ensure that your responses to the
Canada Revenue Agency’s cryptocurrency tax-audit questionnaire
are accurate, relevant, clear, and succinct.

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.