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David Rotfleisch on Tax Obligations in Canada for Unreported Income from NFTs: Analyzing the Holy Rock NFT Creators' Prosecution in Israel

posted 9 months ago

Overview: Israeli Tax Authority Arrests Two in Extensive NFT-Related Tax Evasion Scheme

In March 2023, the Israeli Tax Authority made an announcement regarding the apprehension of two Israeli citizens suspected of tax evasion linked to unreported income exceeding USD $2 million generated from non-fungible token (NFT) transactions. NFTs essentially represent unique digital assets and are indivisible digital tokens. Each NFT’s token ownership is documented on a digital ledger, typically using the Ethereum (“ETH”) blockchain and smart contracts to link the token to specific data, which could be artwork or any other collectible item. Usually, this data is hosted off-chain, often on a cloud-based service, allowing NFT holders to access it. NFT content creators use a public key to verify the NFT token’s history, serving as proof of its authenticity and provenance.

As reported by the Jerusalem Post and the Israeli Tax Authority, the two individuals in question were the Holy Rock NFT project creators, who sought to create unique NFTs representing each individual stone from Jerusalem’s Western Wall, intending to sell them to digital collectors. These two individuals subsequently sold the NFTs generated by the project in exchange for units of the ETH cryptocurrency. They further transferred these ETH units across different cryptocurrency wallets, complicating the traceability of these transactions on the public ledger. Allegedly, the accused individuals did not report any profits resulting from the sale of their NFTs for ETH.

The surging popularity of blockchain technology, including cryptocurrencies and NFTs, has raised concerns among global law enforcement agencies and tax authorities. They worry that these digital assets might be exploited for tax evasion purposes by obscuring the nature of taxable transactions. This concern stems from the intrinsic anonymity offered by blockchain technology to digital asset traders. While blockchain transactions are inherently public, the unique wallet addresses associated with entries on a digital ledger do not reveal the true identity of the wallet holder. In response to these concerns, regulatory bodies such as the Israeli Tax Authority and the Canada Revenue Agency (“CRA”) have implemented rigorous measures to combat the use of digital cryptocurrency assets as a means of concealing unreported income.

Although the CRA hasn’t issued any compliance or enforcement notices specific to the global NFT marketplace, it has done so in the context of virtual currency and cryptocurrencies. Even though the Holy Rock NFT project’s subject matter is clearly tied to Israel, it serves as an intriguing case study for examining the CRA’s investigative powers when it comes to tax evasion and the potential consequences, both civil and criminal, for tax evaders. This article will begin by delving into the fundamental principles of taxing NFTs within the Canadian cryptocurrency tax system. Subsequently, it will elucidate the methods employed by the CRA for investigating taxpayers who employ NFTs in suspected tax evasion schemes, along with the spectrum of penalties that may be imposed on taxpayers who willingly or unwittingly partake in crypto tax evasion. Finally, we will offer some crypto tax tips and address frequently asked questions related to the taxation of NFTs and tax audit investigations.

Why do NFT Dispositions Carry Tax Liabilities in Canada?

As per section 3 of the Canadian Income Tax Act, a Canadian taxpayer’s income encompasses all earnings from any productive source, whether located inside or outside of Canada. This includes income generated from a business or property, which inherently covers the sale of an NFT. In the Canadian tax framework, whenever an asset is disposed of, the resulting gain or loss from that transaction must be calculated, reported, and subject to taxation in the year of the disposition. This taxation applies irrespective of whether the asset is sold for fiat currency or cryptocurrency or exchanged for another asset. Consequently, whenever an NFT is sold for fiat currency or traded for another asset like cryptocurrencies or other NFTs, the Canadian tax system views this sale or trade as a taxable event, necessitating the computation and reporting of crypto gains or losses stemming from the disposition in the year it occurred.

The taxation implications of an NFT disposition for a Canadian taxpayer are evident. The pivotal and technically intricate aspect revolves around whether this disposition should be categorized as a capital gain or as revenue stemming from a business, which can encompass a one-time disposition. This holds significant importance for crypto tax planning purposes because, unlike revenue from a business, only half of a taxpayer’s capital gains will be considered taxable income in the year of the disposition. Conversely, if the disposition results in a capital loss, only half of that loss will be deductible, and it can only be deducted against capital gains. Given the well-established volatility of the global NFT marketplace, distinguishing between capital gains and business income can carry substantial implications for a Canadian taxpayer in determining the extent of tax liability or savings.

Determining whether the profit or loss resulting from a property disposition should be considered capital or income has been the subject of extensive litigation in Canadian tax courts. While the Tax Court of Canada has yet to try a case concerning the sale of NFTs, it is reasonable to expect that these principles will continue to apply in characterizing the proceeds of an NFT disposition. It is crucial to acknowledge that no single factor can solely determine the appropriate classification of the proceeds derived from a property disposition. Each case should be evaluated on its unique merits. However, Canadian courts have consistently outlined specific objective criteria that should be taken into account when determining whether a property disposition was carried out as capital or income. In the context of NFTs, these factors may include:

Frequency of NFT Transaction: For instance, if a taxpayer frequently engages in buying and selling NFTs or demonstrates a high turnover rate of NFTs, it may suggest a business activity rather than a capital investment.

  • Ownership duration: If a taxpayer tends to hold NFTs for short periods, this could indicate commercial activities rather than long-term capital investments.
  • Being adept at NFT marketplaces: A taxpayer’s knowledge or expertise in NFT markets may support a business classification.
  • Relationship to other employment of taxpayer: If NFT trades or similar activities are linked to the taxpayer’s primary employment or other business, this leans toward a business categorization.
  • Time invested in NFTs: If a significant portion of the taxpayer’s time is dedicated to researching potential NFT acquisitions, analyzing NFT markets, or actively managing an NFT portfolio, it suggests a business operation.
  • Financial support: Leveraged NFT purchases and transactions are indicative of a business.
  • Advertising: If a taxpayer advertises their NFT activities as a business or publicly promotes their involvement in NFTs, it increases the likelihood of being categorized as a business.

In a general sense, the primary factor that holds the most weight in determining whether the sale of a property results in a capital gain or business income is the taxpayer’s intent at the time of acquiring the property. The Tax Court of Canada and the Canada Revenue Agency will thoroughly examine the objective circumstances surrounding the property’s acquisition and sale, taking into account the factors mentioned earlier, to ascertain the taxpayer’s underlying purpose for obtaining the property. It’s essential to note that the definition of “business” in subsection 248(1) of the Canadian Income Tax Act encompasses “an adventure or concern in the nature of trade.” This interpretation implies that even a single instance of acquiring and selling property can be classified as business income if the surrounding circumstances substantiate such characterization.

Consequences of Inadequate Reporting of Tax on NFT Dispositions

A taxpayer can be subject to substantial civil or even criminal penalties for tax evasion, which hinge on the degree of his or her wrongdoing. Subsection 239(1) of the Canadian Income Tax Act outlines various scenarios in which a Canadian taxpayer may face significant fines and potential imprisonment for intentionally making false statements on a tax return, participating in such actions, or willfully manipulating or destroying financial records to conceal a tax liability. Conviction under subsection 239(1) can result in penalties ranging from 50% to 200% of the evaded tax or a maximum prison sentence of two years.

The crucial determinant for potential criminal liability in cases of tax evasion is the taxpayer’s state of mind when committing the act in question. Alternatively, subsection 163(2) offers a civil framework for penalizing taxpayers who knowingly or, under circumstances amounting to gross negligence, make false statements or omissions on a tax return (these are often referred to as “gross negligence penalties”). According to subsection 163(2), for a false statement or omission, a taxpayer may be held accountable for the greater of: (1) $100; and (2) 50% of the total tax amount otherwise payable by the taxpayer.

The anonymity provided by digital ledgers to NFT traders has posed challenges for the CRA in initiating crypto tax audits of Canadian NFT traders suspected of tax evasion. The CRA’s existing powers to collect information on Canadian taxpayers during tax audits are of limited use when investigating taxpayers involved in wallet-to-wallet transactions exclusively. However, the increasing significance of digital asset exchanges as facilitators of NFT trading provides a key avenue for CRA tax audits targeting Canadian NFT traders. Section 231.2 of the Canadian Income Tax Act grants CRA tax auditors and investigators the authority to compel individuals to furnish documents or information necessary for a tax investigation. This authority is notably extensive and has historically allowed the CRA to require cooperation from banks and other third-party financial institutions, resulting in the production of statements and records. The CRA has not hesitated to utilize this authority to compel digital asset marketplaces to provide information about Canadian cryptocurrency and NFT traders.

In 2020, the CRA successfully obtained a court order from the Federal Court to compel Coinsquare Ltd., a Toronto-based cryptocurrency platform, to disclose confidential tax information pertaining to the trading activities and cryptocurrency holdings of Canadian users. Therefore, despite the anonymity offered by digital ledgers, the CRA retains the means to audit NFT traders who employ trading platforms and marketplaces for their trading activities.

If the CRA comes across evidence during a tax audit that could warrant criminal charges against a taxpayer, the case is referred to the Department of Justice for prosecution under the Canadian Criminal Code. While there is no restriction on the CRA’s ability to share information collected during a civil tax audit with the Department of Justice, the CRA’s investigative powers for a civil tax audit cannot be exploited to aid a criminal investigation. When the primary purpose of a CRA tax audit shifts towards investigating criminal or quasi-criminal activity, it triggers a taxpayer’s constitutionally protected right against self-incrimination under section 7 of the Canadian Charter of Rights and Freedoms. Furthermore, a taxpayer’s rights under section 8 of the Canadian Charter of Rights and Freedoms safeguard that taxpayer against unreasonable searches and seizures by the state. This nullifies the CRA’s powers under section 231.2 to compel document production for such an investigation. While both the CRA and the Department of Justice are responsible for informing a taxpayer when a tax audit transitions into a criminal or quasi-criminal investigation, in cases where they fail to do so, the burden falls on the taxpayer to challenge any inappropriate use of the CRA’s powers to gather evidence for a criminal case. This necessitates that the taxpayer demonstrate that the CRA’s primary purpose in collecting information during the tax audit was for use in a criminal investigation rather than a civil tax audit, which is a formidable challenge for any taxpayer to surmount.

Tax Pro Tips – Minimize Criminal Liability Risks by Utilizing the Voluntary Disclosures Program

The CRA’s Voluntary Disclosures Program (VDP) offers a crucial avenue to avoid potential criminal prosecution related to crypto tax evasion, including cases involving unreported NFT dispositions. Through the VDP, Canadian taxpayers can proactively disclose any tax non-compliance matters to the CRA before the agency initiates its own inquiry. If a taxpayer meets the criteria for relief under the crypto VDP, he or she may qualify for several benefits, including exemption from penalties for non-compliance, such as gross negligence penalties, partial interest relief on outstanding taxes, and, notably, protection against criminal prosecution.

The importance of a timely and effective voluntary disclosure application cannot be overstated. To be eligible for relief through the VDP, your disclosure must meet specific criteria. First and foremost, it must be truly voluntary, meaning it must precede any enforcement actions undertaken by the CRA related to the non-compliance issue under consideration.

Moreover, your disclosure must be comprehensive. This entails not only including all relevant submissions, calculations, and information pertaining to the specific tax non-compliance matter but also addressing any other non-compliance issues for which you bear responsibility. Therefore, if you find yourself facing unreported taxes stemming from NFT dispositions, along with undisclosed income from other sources, securing VDP eligibility hinges on disclosing and rectifying both forms of non-compliance. Consequently, it is imperative that you engage the assistance of a top Canadian crypto tax lawyer. Such legal tax counsel can assist you in meticulously planning and crafting your voluntary disclosure application. Additionally, they should be prepared to promptly address any inquiries from the CRA regarding the content of your application, ensuring its continued completeness.

Furthermore, beyond enhancing the prospects of the CRA granting tax amnesty, a meticulously crafted disclosure application serves as the foundation for a potential judicial review application to the Federal Court in the event that the Canada Revenue Agency unjustly rejects your voluntary disclosure submission. Our team of knowledgeable Canadian tax lawyers possesses a wealth of experience, assisting numerous Canadian taxpayers grappling with unreported income stemming from cryptocurrency and NFT transactions, in successfully securing relief through the VDP. If you find yourself confronting issues of tax non-compliance related to your digital asset sales, it is imperative that you promptly seek the counsel of a seasoned Canadian crypto tax lawyer. Doing so will enable you to maximize the available relief options under the VDP, while simultaneously averting the severe legal consequences associated with tax evasion.

Frequently Asked Questions (FAQs):

If I exchanged an NFT for cryptocurrency or another NFT instead of fiat currency, is this transaction still subject to taxation?

In the Canadian tax system, a property disposition is taxable regardless of whether the property is sold or exchanged for another asset. Therefore, when an NFT is sold for fiat currency or traded for another asset such as cryptocurrencies or NFTs, it is considered a taxable event, and the resulting gains or losses must be calculated for tax purposes.

When could an NFT be classified as inventory rather than capital property for tax purposes in Canada?

The Canadian Income Tax Act recognizes only two primary categories of property for income tax purposes: (1) capital property, which leads to capital gains or losses upon disposal; and (2) inventory, which is factored into the calculation of business income. While the taxpayer’s intention when disposing of an NFT remains the most crucial factor in determining the income’s characterization, other factors will also be taken into account: (1) the frequency of NFT transactions; (2) the duration of NFT ownership; (3) the taxpayer’s knowledge of NFT and digital asset markets; (4) the connection between NFTs and the taxpayer’s other employment; (5) the amount of time invested by the taxpayer in NFT trading; (6) the taxpayer’s financial support for NFT trading; and (7) whether the taxpayer promotes an NFT trading business in any way.

What authority does the CRA possess to enforce a taxpayer’s submission of documents or information during a tax audit?

The CRA wields significant authority to mandate the submission of documents and evidence. Under subsection 231.2, the CRA is empowered to require documents and records from any individual, even third parties not under audit themselves, as a component of a tax audit. This encompasses digital asset marketplaces, such as cryptocurrency and NFT exchanges, where the CRA holds the jurisdiction to demand document disclosure.

Do the CRA’s investigative and auditing powers infringe upon constitutional and common law rights?

The CRA’s broad investigative powers, when exercised as part of a civil audit, generally do not infringe upon a taxpayer’s constitutional and common law rights. As long as the CRA uses its investigative authority for civil purposes, such as compelling document production and conducting interviews, it typically does not violate the individual’s rights under section 7 or section 8 of the Canadian Charter or the taxpayer’s right to remain silent. However, if the CRA’s primary purpose shifts towards a criminal or quasi-criminal investigation, then Charter and common law rights may come into play.


The information provided in this article is general in nature. Only as of the posting date is it current. It hasn’t been updated and might not be relevant. It should not be relied upon because it does not provide legal advice. Every tax situation is different from the ones discussed in the article because of its unique circumstances. Consult a Canadian tax lawyer if you have specific legal questions.



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