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Combatting Digital International Tax Crimes: Meet the New “J5"

With the winding down of the OVDP, the Department of Justice and the Internal Revenue Service are placing renewed emphasis in the area of international tax enforcement emphasis to cryptocurrency and cybercrimes.  Will the bitcoin and other cryptocurrencies become the next Swiss bank accounts? According to IRS reports, only a small percentage of virtual currency holders in the United States are disclosing their gains. Still, the IRS has been gearing up its investigative function of the cyber world. In November, 2016, the IRS served John Doe summons against Coinbase, Inc., one of the largest U.S. virtual currency exchanges, to obtain the list of 13,000 of its customers. Since many U.S. taxpayers are not filing accurate returns with respect to cryptocurrency there should be a sharp uptick in investigations and ultimately prosecutions for tax evasion, money laundering and related crimes.

The U.S. experience with cryptocurrency is part of a worldwide phenomenon where transparency goals and objectives of the taxing authorities of numerous jurisdictions have been frustrated. Now, it appears, that countries are going to work with one another to identify and prosecute the “evil-doers”.

Attorney General Sessions Issues Cyber-Digital Task Force Report

Attorney General Jeff Sessions issued a press release on Thursday July 19, 2018, the Department of Justice, Office of Public Affairs,  announcing the Attorney General’s Cyber-Digital Task Force. See Dept. Justice Press Release 18-954.   The report provides a comprehensive assessment of the cyber-enabled threats confronting the nation, and identifies means by which the Department of Justice combats those threats. The Cyber-Digital Task Force was organized in February 2018 and was to provide answers to two basis questions: (i)  how is the Department of Justice responding to global cyber threats?; and (ii) how can federal law enforcement accomplish its mission in this area more effectively?   The report issued on July 19, 2018 answers the first question.

The report begins by focusing on one of the most pressing cyber-enabled threats confronting the nation: the threat posed by malign foreign influence operations.  Chapter 1 explains what foreign influence operations are and describes how foreign adversaries have used these operations to target our democratic processes, including our elections.  The report concludes by describing the Department’s efforts to protect the 2018 midterm elections and announces a new Department policy that governs the disclosure of foreign influence operations. Chapters 2 and 3 of the Cyber-Digital Task Force Report address other significant cyber threats, particularly sophisticated cybercrime schemes, and what procedures are being deployed to combat them. Other chapters pertain to: (i) the role of the FBI in responding to cyber incidents; (ii) recruiting and training qualified personnel; and (iii) identification of policy priorities and charting the Task Force’s future efforts.

International Attacks on Cyber and Cryptocurrency Crimes

The marshalling of assets and human resources to move against crybercrime and related tax evasion is not limited to efforts being undertaken by the United States. Instead, it is an enforcement program that is being undertaken by many countries. The interest of the world’s tax authorities in digital currencies has grown in tandem with the proliferation of use of such currencies and increased values realized by owners last year.  Compare the growth in the number of investors and increase in values in cryptocurrency worldwide with the downward spiral of tax compliance and gross underreporting of cryptocurrency transactions, include attempted efforts to swap cryptocurrencies on a non-taxable basis.[1] Tax compliance in this area is hardly impressive.

Under Title 31 USC, FinCEN has also issued guidance with respect to persons administering, exchanging, or using convertible virtual currency, i.e., a medium of exchange defined as one that operates like currency in some environments, but does not have the attributes of real currency. Virtual currency does not have legal tender status in any jurisdiction, but convertible virtual currency has an equivalent value of, or may act as a substitute for, real currency. The guidance defines virtual currency arrangements as involving a “user,” an “exchanger,” and an “administrator.”[2]

The J5

On July 2, 2018  the tax authorities of the United States, the United Kingdom, Canada, Australia, and the Netherlands announced the creation of a crime-fighting alliance called the Joint Chiefs of Global Tax Enforcement (J5). The J5  will collaborate on cryptocurrency issues, tax cybercrimes, and other matters, in an effort to enhance their effectiveness in investigatory powers in this area. The J5 alliance comes months after the OECD called on governments to use cooperation and collaboration to increase its moving against persons engaged in carrying out global tax crimes. The alliance focuses on information sharing, joint exercises and joint investigations. Part of the J5’s initiatives is to combat cyber-crime and the growing threats posed by cryptocurrencies.

As reported in Tax Notes International, July 23, 2018, the members of the J5 anticipate that their moving in to cybercrime and cryptocurrency crimes will result in tremendous recoveries of assets, unpaid taxes and proceeds of money laundering subject to forfeiture. The OECD predicted that the rate of return for enhanced enforcement will rate from 150% to 1500%. 

The winding down of the offshore bank account phenomenon is replaced if not substantially eclipsed by internet trafficking in goods and services based on cryptocurrency. Taxing authorities are concerned that cryptocurrency offers participants to remain somewhat anonymous by using false names and obscured web addresses in covering up the paper trail of financial and tax crimes. But what about others who accept payment in cryptocurrency for goods, services, funds, etc. ? Do such persons run the risk of being subject to investigation and prosecution if they accept payment in cryptocurrencies or engage in other commercial activities related to Bitcoins and other cryptocurrencies?  

The OECD Response

In November of last year the OECD finished its fifth round of global forums dedicated to addressing offshore tax evasion, money laundering, and other tax crimes. The conference was held in London and was attended by more than a worldwide representative group of more than 200 tax crime and economic crime experts.  In its “closing statement” the OECD acknowledged that the purpose for the forum was to acknowledge the threat that tax and economic crime poses to national and international finances, society, and security.  Data leaks from the Panama Papers and the more recent ‘paradise paper’ evidence the degree of tax fraud being engaged in on a global basis with the commonly employed factor of engaging in cryptocurrency purchases, exchanges and redemptions into recognized forms of currency.

Tax authorities, law enforcement officials, and other stakeholders have been meeting about every 18 months since the forums began in 2011, but the November 2017 forum is notable because it ended with five priority items for governments to tackle before the next meeting:

  • ensure that professional enablers play their part in tackling tax crime;
  • increase international and cross-government cooperation;
  • implement a set of 10 newly released global principles;
  • strengthen intelligence and data sharing capacities; and
  • build crime-fighting capacity in all countries.

The 10 global principles were released during the forum and are meant to serve as a measurement tool for governments in evaluating the efficacy of their tax evasion-fighting strategies. Those principles are: (i) ensure tax offences are criminalized; (ii) devise an effective strategy for addressing tax crimes; (iii) have adequate investigative powers; (iv) have effective powers to freeze, seize and confiscate assets; (v) put in place an organizational structure with defined responsibilities; (vi) provide adequate resources for tax crime investigation; (vii) make tax crimes a predicate offence for money laundering; (viii) have an effective framework for domestic inter-agency co-operation; (ix) ensure international co-operation mechanisms are available; and (x) protect suspects’ rights.

Overall, the OECD principles are a rehash of ideas proposed in previous forums, calling on tax authorities to beef up their investigative powers, tighten their domestic and international cooperation frameworks, and develop strong crime-fighting strategies, among other principles.

J5 Alliance

The J5 alliance said it plans to focus on the more digital aspects of tax enforcement such as cybercrime and cryptocurrencies. The J5 further announced it plans to target professional enablers of tax crimes through joint investigations. The group also said it intends to share data analytics methods and jointly develop tactical plans.

The governmental agencies involved in the J5 include the IRS Criminal Investigation division, HM Revenue & Customs, the Canada Revenue Agency (CRA), the Dutch Fiscal Information and Investigation Service, the Australian Taxation Office (ATO), and the Australian Criminal Intelligence Commission.

The collaboration takes a page out of the OECD’s tax crime playbook and comes at a time when many of the agencies involved have faced a fair degree of frustration and adversity in exposing and successfully prosecuting tax crimes because of decreasing manpower or other issues. Although governments have long discussed collaboration and coordination strategies via the OECD,  the OECD has organized a tax evasion taskforce of 38 countries known as the Joint International Taskforce on Shared Intelligence and Collaboration (JITSIC) that includes the J5 countries, the J5 alliance is really a new initiative.

United Kingdom’s Scorecard of Late

It was reported by the United Kingdom HM Revenue & Customs (HMRC) which served as the host for the OECD Fifth Forum, that its tax gap has been steadily decreasing. For the 2016-2017 year the gap was 5.7% the lowest it had been in close to 15 years. As to overshore tax evasion the HMRC has clawed back 2.8 billion pounds in the past 8 years and another 100 million pounds is expected to be received under its Panama Papers investigation. Four individuals were arrested. The HMRC has a “No Safe Havens” campaign against offshore evasion, which is rooted in international cooperation and informational exchanges.

United States’ Scorecard

The Criminal Investigatory Division of the IRS announced last Summer it would focus more attention on offshore investors and cybercrimes through two newly formed enforcement initiatives: a national coordinated investigations unit and an international tax enforcement group. On the other hand the are reduced resources at the IRS which has led to a significant decrease in investigations of almost 25%. Still, the reported  number of international cases is growing: In 2015 the division completed 186 cases, and by 2017 the number grew by approximately 55% to 283 cases.

Already, the IRS has made some inroads in its emerging battle against cryptocurrency investors that fail to report their profits. Last November the U.S. District Court for the Northern District of California in United States v. Coinbase Inc., No. 3:17-cv-01431 (N.D.Cal. 2017), ruled that the IRS could partially enforce a John Doe summons against the country’s largest virtual currency exchange — Coinbase Inc. — and force the company to hand over information on some customers. The company, which now has about 20 million customers, told 13,000 users in February that it would be giving the IRS information on their accounts. See Tax Notes International (3/5/2018).

Canada Isn’t Winning

Canada is reported to have insufficient data especially in tracking and identifying offshore tax evasion. The government has recently made additional investments into the CRA to conduct more audits and get better data about taxpayers. The CRA is now conducting over 1,100 audits on taxpayers implicated in the Panama Papers. Canada further suffers from a lack of informational transparency. It is definitely behind the transparency curve when compared to its ally along its southern boundary.

Australia and the Netherlands Are Trying to Change Past Perceptions

Australia has intensified its tax compliance work in recent years. Participation in the J5 openly sets forth it commitment to fight against tax avoidance and crimes. By March 2017 the ATO reported it had over 280 open audits and had raised AUD 545 million (about $403 million) in liabilities with AUD 250 million in cash collections, as per the comments ATO Commissioner Chris Jordan.

As to the Netherlands, it recently has promulgated a host of anti-avoidance and evasion rules and plans to increase the number of anti-abuse provisions in its tax treaties.

International Patchwork

J5 members anticipate that the alliance will be effective because it is small and should be able to operate flexibly. But the group says it won’t shut out other taxing authorities, and it plans to share the results and benefits of its collaboration with international partners. The tax work envisioned by the group is important, not just in terms of content but also because of its anticipated timeline.

Besides the J5, the “BRICS” countries, Brazil, Russia, India, China and South Africa are also holding meetings and embarking on joint initiatives to combat tax evasion and cybercrime.

[1] In Notice 2014-21, 2014-16 IRB, IR 2014-36, the IRS provided guidance in a question and answer format on the tax treatment of virtual currency. Virtual currency, the government announced is not “currency” and instead is to be treated as “property” for US federal tax purposes and the general tax principles that apply to property transactions apply to transactions using virtual currency. For example, wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes. (Notice 2014-21, FAQ No. 11). The taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value (FMV) of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. (Notice 2014-21, FAQ No. 3) Taxpayers must determine the FMV of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the FMV of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied. (Notice 2014-21, FAQ No. 5) The basis of virtual currency that a taxpayer receives as payment for goods or services is the FMV of the virtual currency in U.S. dollars as of the date of receipt. (Notice 2014-21, FAQ No. 4) ,

A taxpayer has gain or loss on an exchange of virtual currency for other property. The like-kind exchange rules in section 1031 provide little, if any, comfort.  It is doubtful that the Cottage Savings doctrine could apply as well unless and until the Service carves out some safe ground for cryptocurrency exchanges. If the FMV of property received in exchange for virtual currency exceeds the taxpayer's adjusted basis of the virtual currency, the taxpayer has taxable gain. If the FMV of the property received is less than the adjusted basis of the virtual currency, the taxpayer has a loss. (Notice 2014-21, FAQ No. 6) The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets. A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset. (Notice 2014-21, FAQ No. 7).

[2] FIN-2013-G001, “Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies” (Mar. 18, 2013) (also noting that since virtual currency is not “currency” under the BSA, an exchange could not be considered one between dealers in foreign exchange); FIN-2014-R001 “Application of FinCEN's Regulations to Virtual Currency Mining and Operations” (Jan. 30, 2014); FIN-2014-R002 “Application of FinCEN's Regulations to Virtual Currency Software Development and Certain Investment Activity” (Jan. 30, 2014); FIN-2014-R007, “Application of Money Service Business regulations to the rental of computer systems for mining virtual currency” (Apr. 29, 2014); See also FIN-2014-R012 “Request for Administrative Ruling on the Application of FinCEN's Regulations to a Virtual Currency Payment System” (Oct. 27, 2014). See Tuner, Albrecht and Rocha, “A Historical View of the Walter Anderson Tax Evasion Scheme,” J. Tax’n (May 2018).