Best practices for crypto asset tax reporting

Laura: Thank you for joining Gowling WLG for this podcast. We are an international law firm covering a wide range of sectors and industries. Visit our website, gowlingwlg.com, to get all our latest insights. In this episode we're going to discuss cryptocurrencies and tax. More specifically, the best practices for crypto asset tax reporting. My name is Laura Gheorghiu and I'm a partner specializing in tax planning with Gowling WLG Canada and a member of the firm's Blockchain and Smart Contracts group. Gowling WLG's multi-disciplinary Blockchain group is a fact leader and legal pioneer in the Canadian Blockchain space, having advised a number of platforms, exchanges, digital wallets, investment funds, financial institutions and technology companies in this space. Including one of the co-founders of Ethereum. I'm very happy to introduce our guest today. Roger Brown, global head of tax and regulatory affairs at Lukka.

Roger: Hello. Thank you.

Laura: Lukka is the leading crypto asset middle and back office software and data provider. They offer crypto tax solutions for CPAs and tax professionals called Lukka Tax for Professionals. A crypto asset tax preparation solution, built in partnership with cpa.com, that helps CPAs and tax professionals prepare their clients crypto taxes. They also offer a variety of software and data solutions to businesses, financial institutions and individuals that help collect, standardize and manager their crypto transaction data. S&P recently announced the launch of crypto asset indices, which will be supported by Lukka's institutional grade pricing data, and many exchanges and accounting firms have also publicized their relationships and partnerships with Lukka. Roger is based in the US and before joining Lukka had experience in international accounting at law firms as well as with the US Internal Revenue Service. So let's turn to today's topic. Best practices for crypto asset tax reporting. Today's podcast came out of a discussion that Roger and I had in the client context. In Canada we're seeing an increased awareness amongst crypto investors as  to the median tax reporting obligations. The Canada Revenue Agency and Revenue Quebec have clarified their positions that all crypto transactions are taxable events. It's really only the last year or two that we have seen most individual investors and traders begin to tackler their tax filing obligations. I think a lot of it has to do with rising prices for various currencies after the 2018 crash, and the fact that many have finally cashed out into Fiat, and with the money in the bank feel an increased urgency to report their trading activities to the tax authorities. Roger, is this something that you're seeing on a broader scale?

Roger: Absolutely. I would say that this trend is driven by a variety of factors. Number one, the difficulty that people had in calculating gains and losses. Number two, the number of trading venues people transact in digital assets. It's in stark contrast to the typical trading in traditional financial assets where people may have one or two, perhaps three, brokerage accounts. They can easily login and get their gain loss statements. That is not the case for many exchanges where people trade. They trade not only in their local exchanges in the same country where they live but also, literally, across the ecosystem. In light of that there are many challenges that people have in gathering the data, or reconciling the data and producing the taxable income amounts they're responsible for, under US or Canadian or most other countries under their laws. I would also say that from an enforcing perspective, on the flip side, governments are having the same calculation challenges because they, in enforcing revenue laws, have similar data challenges and also discovery challenges that they have in determining whether people have taxable income.

Laura: I think that's a very valid point and that's really the challenges I am seeing with clients coming to me wanting to clarify their reporting obligations but they have volumes of data that are overwhelming. They have wallets that they've lost the keys to. They have different transactions that are not easily identifiable as to whether they are actually at this position over crypto asset or not. Sometimes it's just a moving of the same bitcoin from one wallet to another. Sometimes it's a different naming or terminology that's being used and sometimes it's just the kinds of transactions. Air drops. Revenue from mining that is not always easily identifiable in terms of what should be the tax implication. The other point that you made is the increased action by the tax authorities to try to gather this data. In Canada we joke that the tax returns are really a good indication of where they are in their auditing process. So the Quebec tax return now has a box you have to tick, whether you have been holding or trading in cryptocurrencies. I believe there's something similar in the US as well. So clearly that's where they're at. We're seeing a lot of data gathering efforts on their parts. We think in the US, IRS has actions to obtain court orders to get information about traders on certain exchanges or holders of crypto on exchanges, I think, in the US you had Coinbase, Circle, Poloniex. In Canada very recently, just in February of this year, the CRA obtained a court order against Coinsquare. So they're hoping to use this data to mine this data for information about income tax and sales tax on compliance. Is that sort of your experience as well with your clients?

Roger: Yes. The IRS started this when they were seeing public reports that some exchanges were saying they had 30 plus million customers. They looked internally and the government saw that they had about 900 tax returns reporting what they saw to be crypto. Obviously you don't need to be a math wizard to say that if 30 million people are transacting in crypto, in one exchange only and only counting 900 returns reporting crypto, there's a huge gap. It might have been increasing for governments to raise revenue. There's a ... effort. So the government submitted a subpoena and successfully received the ability to request information from one of the exchanges. They've expanded that. Only some of those actions are public. You mentioned ones that are public. The 2017/18 action about Coinbase. More recent actions in the press have involved Kraken, Circle/Poloniex. You mentioned Coinsquare and there's others around the world. There are also actions that are not public where governments are requesting that information, and receiving that information, and the point we're now is raising the stakes of people going to self-declare. People making mistakes on their return of that income and that's one type of discussion. There's a very different kind of discussion where the government requests have you trade crypto? Or they're increasingly putting out FAQs and other guidance saying crypto transactions are taxable and you still don't self-declare. The IRS has initiated a program called 'Operation Hidden Treasure'. You don't want to part of something, unaware, under a program of that name where they're using this information and comparing the data they're getting from exchanges. Not only exchanges domestically but they're also getting information from other governments that are also subpoenaing exchanges and then exchanging that with the different governments. Five countries have formed J5. It's a largely criminal enforcement activity but they're also exchanging and getting information on civil actions where they are seeing who has crypto. Not only are they getting exchange records but they're also getting transaction hashing wallet addresses. Once you get that they're engaging with Blockchain data attribution companies to get the wallet history. The wallet history, you see the historic transactions involving crypto for the particular wallet, and then they are associating that with personal account information that they're getting from the exchanges. Then they're seeing that people have activities from 2013, 14, 15, 16 and then it's a question of the statute of limitations. In the US, and I know for Canada as well, it can be shorter limitations. It could be 3 years, 6 years, depending on, at least in the US, for the amount of potential understatement. But if they can show an intent to not report tax then it gets into fraud discussions and they're easing those statute of limitations for that.

Laura: I think that's a very valid plan. When I was talking there's a lot of very important issues that you've raised. One of them being that obviously Canada is one of the 5 countries and is getting this data. The CRA believes it can use it usefully, fruitfully, by identifying non-compliance. The second point that I think is really important is that they are not going at this blindly. They're using the most up to date technology, including Lukka and others, to be able to piece together this data and to useful information about non-compliance. When the individual or company uses an exchange under AML and ... client rules, the exchange does have identifying information about the user. So even though not all transactions can be traced to one person, necessarily, they are sort of breadcrumbs in the system that allow for specific individual to be identified, eventually. I think that's really important to know that. It's not a matter of if transaction will be traced to somebody but when, I think, in terms of what's available technology and where the tax authorities are on in the process. The other point that I really want to stop on and it's quite important is this idea about the tax finding obligations and the prescription period. Obviously the tax authorities, Canada Revenue, Revenue Quebec, and others across the world have taken the position that crypto transactions are taxable when they occur. So not when you go and convert your crypto into Fiat and you have that money in your bank account, although obviously that's easily traceable to you now, and can be flagged because you go from having two thousands to five million or twenty million in your account, but also in the crypto space as you trade from one currency to another or use it to buy up product services, etcetera. So the question really is what do you do with this past non-compliance? How do you address it? The reason why it's important to address it is because the government has some tools in its arsenal to encourage you to do that. One of them is this idea that if you have not complied and reported your earnings, and it's a substantial amount, it's not missing $50.00 you forgot to report from a yard sale, it's millions of dollars. There's no limitation when they can come back and reassess you. In Canada, our general prescription period is 3 years after your notice of assessment is issued. So imagine, if April 30 is your filing deadline and you get assessed on June 15, well it's 3 years from that date, normally, that you have to worry about. But if you have failed to declare large amounts like this there is no prescription period and they can come back 5 years later  when they've got all their ducks in a row and reassess you. In the meantime you have all this interest that's accumulating. You have penalties applying and, if it's really a false statement or omission as to a large amount, there's also gross negligence penalties which are 50%25 of the amount unreported. So you can really eat away at what you've earned to fall into these. That's why reporting is so important even as we say despite all the pitfalls of that. So I think what I'm saying to a lot of my clients is you have to now look very carefully at reporting for this year what you have earned, but also at the same time as part of that same conversation, looking at what you have missed reporting in previous years and looking at how am I going to report that. Is it whether just as simple as amending a past return to report that income or, as part of the same conversation, do I want to voluntarily go to the CRA and ask for some penalty relief under the Voluntary Disclosure Program? That's sort of an additional option where, again, it has to be voluntary. They cannot have started looking at your file, sent you a request, one of their famous questionnaires is a 16 page questionnaire that they send out and basically that's everything you've ever done in the crypto space, ever, and even has a question, "Is there anything else you would like to tell us?" Anything else you'd like to confess. So once you get that it's a little bit late. But everybody else can go and ask for voluntary disclosure and try to get these penalties waived. So you're paying the tax but at least you are not having the double hit. Because that's why a lot of clients are hearing that and they're saying, "Okay. I get this. This is great. I want to do this." But then it gets down into the nitty gritty and they go to their accountants, and once you start preparing these returns, and that's where we hit a wall. Because it's not easy to get there and one of the problems, and you and I have talked about this a lot is, getting to the cost base. I want to calculate my gains. I need to know what the cost of my crypto that I'm selling. That's really where the technology solution is really vital, isn't it?

Roger: Absolutely. You've put a number of really important concepts on the table. I'll try to address them with the following. If you decide when you're now looking at your tax return and you say, "Yes. I transacted in crypto and I've sold the crypto." Clearly your proceeds are whatever you sold it for. The fair value of the Canadian dollars, whatever currency, or if you're exchanging crypto for crypto, what is the value of this? You then necessarily have to ask yourself, "What did I sell? What it is the tax basis?" From the Canadian rules you will be using the average cost basis for that relevant digital asset. Great. Then you necessarily have to determine, "I've sold things in the past. What did I sell and how much is my average basis was taken away with those prior ... sales." If you're under the US rules, the US does not permit average cost basis. You're using an accounting method of LIFO, FIFO or something else that you could choose. But, again, necessarily taking away the tax basis of what you sold. So if you find religion in this current year with regard to I'm going to comply with my obligations, you necessarily are putting pressure on what prior tax practices are and that's why more than a third of our users actually are purchasing, and I'll get into what that means, support for prior years. What I mean by purchasing, we really support customers in two ways. We might ... more than that. In terms of calculating gain loss we have a platform that users can login to and for 1999, for current year, a $9.95 rate by a year compute their gain loss calculation by uploading their transactions, computing taxable income and then determine their appropriate accounting method to support a cash reporting for a prior year. Secondly, in order to claim a prior years, they are more often than not going up and cleaning up that prior because otherwise if they don't clean up their prior years for what they sold, now it really shows that their current year reporting is defective because they haven't properly accounted for the tax basis. We also licence products to accountants. Many of them the large accounting firms in the world are licencing our products because traditional software tools do not support the complexity to crypto data. As you had touched on earlier, there's different nomenclature, different tickers for different assets, different data formats, etcetera. There needs to be that normalization as well as putting the data in a single software tool in an ingestible way that doesn't require manual manipulation. Our software does that so that's why many of the larger accounting firms to use our software to compute gain loss and income for their clients. The final ways where people have very complex transactions we actually have a customer success team, more than a dozen individuals, whose day jobs and night jobs are managing the complexity of crypto data. It's often the case that attorneys, or accountants, will engage us to do that. Either just for their own tax compliance or when they're under audit we regularly, many number of times a week now, are in teaching with attorneys and accountants to support them. Doing the calculations that they're not able to do because it really does require a special expertise in the data and that's why we have a number of engagements supporting people to do.

Laura: Yeah and that's an important point because when we want to calculate a gain, whether it's a capital gain or an income inclusion we need to two values, really. We need the cost base. What exactly did I pay for this thing? We need the fair market value. What am I selling it at today? That's another point that is actually difficult to calculate. Obviously if I trade on the exchange I know what the rate is. But if I'm selling off my wallet to somebody else on their wallet, sort of a back office or person to person sale, getting that right value for that transaction is really important. That's something else where it's key to look at a good and logical solution in order to determine what is the sale price of your transaction.

Roger: Laura, you make a good point that people often transact in digital assets where cash is not used. If cash is not used in a transaction a pricing source is needed to determine the proceeds, the value for which you received. If you trade bitcoin for XRP, bitcoin for Filecoin, each for Filecoin, you need to determine what the Canadian dollar value is. That's why we've developed a product, public of prime. What it seeks to do is determine the price of a digital asset where cash is not involved in the digital transaction. We've developed it to align with US SCAP and IRF standards to determine the most reliable price for that on an established market. It looks through a series of variability factors to determine what is the most reliable price to determine to the value of digital asset where cash is not involved. We've licenced that product to a number of institutions. I just market in S&P, publicly, and many other institutions also use it for purposes of determining many tax and accounting business functions that they use internally.

Laura: Those are very good points, Roger. I think what we're talking about really is getting a solution that allows you to calculate your cost base, calculate your proceeds in this position, trades your transactions in a way that are going to allow you to have good data for your tax reporting down the line and that's essential. The solution also needs to be aligned with the tax rules in your jurisdictions. For example, if you're in Canada and you're doing mining of crypto, you need that solution to account for mining revenues when they're generated and not when they crypto is ultimately sold, which is the rule in some other jurisdictions. So those are really important things to look at when shopping for, if I may say that, shopping for a technology solution. If I can just shift gears and as part of that discussion of how do we comply. What the investor usually does is to look to their accountant and say, "I need to file my return. Help me calculate this." They realize they don't have, necessarily, what their trusted accountant, that accountant may not have the technical understanding or the software support, technical support but then they engage somebody like Lukka to help calculate the revenue and gains. The problem in all this is that there's a lot of decision making around how are we going to comply. What are we going to declare? Do I amend past returns to report my income? A lot of that, if it is not couched in solicitor/client privilege, so there's a not a lawyer involved in the process and was advising on this, is possibly available to tax authorities if they so request. So I think the other important point is that when you're looking at I need to comply with my tax obligations, I need to look at this carefully and calculate the amount and decide what I want to do, you should really enter the process from the point of view, I need to engage my tax attorney to have her engage the accountant, and the tax software solution, to feed into that calculation for me. Because all that discussion will then, if done carefully and in the right way, be subject to client privilege and the CRA will not be able to come and sort of kick the tires and say what, "Was your rationale and how were you thinking through your decision?" You want to be able to do that in the comfort of your office without having the risk of the CRA being able to review your rationale as you go through it. So I think that's a really important point.

Roger: Yeah, we're seeing that exact trend, as you say in Canada and the US and most other jurisdictions, that there is an attorney/client privilege. There are weaker privileges for accountant/client privilege. It's not as strong as the attorney client privilege. So we are being engaged  with counsel. There's, in the US, something called a ... Agreement, after a case, that same notion is in others where although we have attorney's on staff, like myself, the agreement allows, we're not rendering legal services, we're providing software. As a result of that what we don't want to be doing is forcing treatment and narrowing tax payer's options inside our product. What we do is track to the ecosystem transactions which are not specific. We then research and analyze in local country laws around mining, staking, transacting crypto for crypto, crypto for cash. Whether somebody's passively trading versus it's their day job. All of those kinds of things and tax treatment differs per country and even inside each country there's ambiguity as to where the lines are drawn. So in the course of deciding where to draw those lines there are legal determinations saying it's advisable to have counsel weigh in on or an accountant, the most strongest privilege is attorney, and then we use our software accordingly. Or another professional will use it, or even a tax payer can use it, to make those lines. That's how we design our software and our reporting output so it can be done accordingly. I think just to put a bow around the topics that we've talked about, it's really a team approach of an attorney, an accountant, a software solution to deal with the complexities of the data as the first resting point. The second resting point is that the governments are increasingly using technology themselves to audit. They are also using companies like us. Either we have some engagements with tax authorities and others do as well, but we have found that people, when they use software solutions like ours, they're getting different results. We had put in the same data inside different software providers and we get different results. Why that's the case, I'm not sure. We actually not only have our own financial audit for our own books, we actually have undergone SOX audits to determine the results that the accuracy of our calculations over a sustained period of time. We spent significant amounts of money to do SOC 1 type 2 and SOC 2 type 2 audits. So when people are engaging with choosing a solution they really want to do that because necessarily if the government has a provider that doesn't have those kinds of controls, from an evidentiary matter, the government will have difficulty relying on the output of that. They will need to understand and appreciate every time 2 + 3 + 4 goes in that number 9 is going to come out and every different data format, etcetera, and if they can't prove that the output data cannot be relied on. That's the reason why companies like mine have undergone SOX audits at the expense because they really may be relying on defective calculations. We have actually seen that now in one of the audits that we are actually engaged with by counsel where the IRS is questioning an audit report that literally increased a tax payer's income by 4 and there're actually errors in the calculation that we have seen and the government, I think principally is actually saying, "Let's come to what we think to be the right answer. We agree that there're problems with whatever, and not being result oriented." They're being principled to say, "Let's get to the right solution because we just want to get to the right number as opposed to the highest number." and that we've found very helpful.

Laura: That's important as well. It's not just about using the right software to calculate your taxes so that you avoid having gross negligence penalties applying and you have prescription applying but it's really also giving you a evidentiary tool and an audit because there will be this to and fro with the tax authorities between their way of calculating things and then your way. You should have a tool that you're comfortable and confident in then that gives your tax lawyers, down the line, or your accountants down the line, an objective to that assessment, better material and a stronger position to support your filing position to begin with. So, if I can just mention the key takeaways here. First, it's really the right time to begin looking at tax compliance with respect to crypto transactions. That practice is it. Secondly, it's really, as part of that same assessment, the right time to look at dealing with past non-compliance and how you want to address it. Third, and I think that's the most important takeaway from our discussion, it's essential to have the right team in place in order to allow you to do both your current reporting, your past reporting in a way that is correct and is defendable in front of tax authorities. I want to thank you so much, Roger, for joining us. It was really a pleasure chatting with you and thank you all for listening. I hope you found this episode informative. Please don't forget to visit our website, gowlingwlg.com, to subscribe to our latest insights.