Published: January 20, 2025
The FBI developed a cryptocurrency called NexFundAI as part of an investigation into price manipulation within the crypto markets, according to a government announcement in October. This Ethereum-based token was crafted with assistance from “cooperating witnesses.” Following the investigation, the Securities and Exchange Commission brought charges against three “market makers” and nine individuals accused of manipulating the prices of the cryptocurrencies in question. Concurrently, the Department of Justice indicted 18 individuals and entities for what they described as “widespread fraud and manipulation” in the crypto markets.
The accused are said to have made misleading statements about their tokens and conducted “wash trades” to artificially inflate trading activity, according to the prosecutors. The three market makers involved — ZMQuant, CLS Global, and MyTrade — are alleged to have engaged in or plotted wash trading activities for NexFundAI, without knowing that the token was actually created by the FBI.
Per the legal documents, the defendants behind several cryptocurrency ventures are accused of making misleading claims about their crypto coins and performing fake transactions to simulate market activity. Companies were hired to perform these wash transactions in exchange for payment. This deceptive strategy was purportedly used to make the tokens appear as lucrative investment opportunities, drawing in new investors and buyers, which in turn drove up the token prices. It’s alleged that the defendants then sold their holdings at these inflated values in a scheme known as a “pump and dump.” Among these entities, Saitama, which was one of the largest, once boasted a market valuation in the billions.
How do these fraudulent schemes work? You may have heard terms associated with these types of schemes in other scenarios, such as “wash transactions” and “pump and dump.” This article will examine how fraudsters make millions through the use of these tactics, scamming innocent investors out of their hard-earned money.
Wash Transactions
A crypto wash transaction, commonly known as wash trading, involves an investor or group of investors executing trades where they buy and sell the same cryptocurrency to themselves or in coordination with accomplices, creating artificial trading volume.
This practice is designed to inflate the apparent liquidity and interest in the cryptocurrency, misleading potential investors by suggesting there’s substantial market activity. The increased volume can manipulate price indicators, potentially triggering automated trading algorithms or deceiving other traders into believing there’s genuine demand. This manipulation can artificially inflate the price, encouraging more investors to buy in and drive the price even higher.
Once the price is sufficiently elevated due to this perceived popularity, the perpetrators sell their holdings at the inflated price, often before the market corrects itself, leading to what’s known as a “pump and dump” scheme. Wash trading is illegal in many jurisdictions due to its deceptive nature, as it doesn’t involve a real change in beneficial ownership and is intended to manipulate market perception and prices, particularly problematic in the less regulated cryptocurrency markets where there is more anonymity in terms of who is buying and selling, and less investor protection framework.
Pump and Dump
A “pump and dump” scheme is a form of securities fraud where the price of a stock, or in this case, cryptocurrency (the “pump”), is followed by the sale of the asset by the schemers at the heightened price (the “dump”).
First, fraudsters promote the asset through various channels like social media, newsletters, or chat rooms, often using paid promotions or spreading false or exaggerated information about the asset’s potential for growth, upcoming announcements, or partnerships. This manipulation is aimed at creating hype and attracting investors to buy into the asset.
In many cases, select individuals or insiders will be able to buy the asset at presale value, meaning they will be able to acquire the crypto coin at its lowest point. These people usually have a large portion of the total pool of available crypto tokens, meaning their trading actions can drastically alter the market price of the coin. These people are referred to as “whales.” Though these people will usually make representations about them not selling the coin until a certain time, be very wary of such statements as they turn out to be untrue in many cases.
Second, the coin will be released to the public, who will buy the coin and inflate its price. Once the price has been sufficiently inflated due to the influx of new buyers, the original promoters/insiders, who hold significant amounts of the asset, sell off their holdings at the peak price. This sale leads to a rapid drop in price as the demand was artificially created and not based on genuine market interest. The result is that the promoters/insiders, who were able to acquire the coin at a very low price, leave everyone else who bought the coin at a higher price holding the bag, as the price of the crypto coin after the whales sell will be almost zero.
The scheme exploits the psychology of FOMO (Fear Of Missing Out) among investors, who might rush to buy the asset at its peak out of fear of missing out on the next big coin, only to find themselves holding a devalued asset once the whales have sold off their shares. These types of schemes will generally only benefit the whales/insiders due to how easily it is for them to sell off their assets and the drastic drop in price that results from this.
This can result in significant financial losses for those who bought in during the “pump” phase. Pump and dump schemes are illegal under securities laws in many countries because they involve market manipulation and deceit. Regulators like the SEC in the U.S. and OSC in Ontario actively pursue and prosecute individuals and entities engaged in such schemes, especially in the more opaque markets like cryptocurrencies where such practices have become prevalent.
Canadian Tax Treatment of Losses From a Crypto Pump and Dump
In Canada, losses from cryptocurrency pump and dumps can potentially be claimed as capital losses for tax purposes, but there are specific conditions that need to be met. In order to claim a capital loss, the cryptocurrency must be disposed of, which means the investor must sell, trade, or otherwise realize the loss.
In the case of a pump and dump, where the value of the asset plummets to nearly zero, investors might still hold the token, thus incurring an unrealized loss. To realize this loss for tax purposes, the investor would need to dispose of the token, possibly by selling it for whatever minimal value it retains or by trading it for another cryptocurrency.
The capital loss can then be used to offset capital gains in the current year, with any unused portion of the loss able to be carried back three years or forward indefinitely to offset future capital gains. However, if the crypto activity is considered business income rather than capital gains, the treatment could differ, potentially allowing for a full deduction against business income. Characterizing the loss on a business or capital account may require a legal analysis from a knowledgeable Canadian crypto tax lawyer, as it is a fact-based assessment and is not always straightforward.
Canadian courts have listed several factors that differentiate income earned on a capital or business account. These factors include:
- The taxpayer’s intention when acquiring the asset (the most important factor);
- Length of ownership – brief ownership of crypto typically indicates a trading purpose and, therefore, business income;
- Transaction frequency – extensive buying and selling of crypto typically indicates a trading purpose and, therefore, business income;
- Background knowledge – advanced knowledge of crypto markets typically indicates business income;
- Time spent – spending a substantial amount of time studying crypto and the crypto market, as well as managing a portfolio, typically indicates business income;
- Financing – debt-back investment typically indicates business income, and
- Advertising – if the taxpayer makes it known that they deal in or are an expert in crypto, that will typically indicate business income.
While intention is the most important factor, it may be hard for the CRA to prove the taxpayer’s intention when they acquired the asset. In these cases, they may look to the length of ownership and transaction frequency to infer what the taxpayer’s intention was while considering the other listed factors as well. If you trade frequently, you may be at risk of the CRA recharacterizing your crypto dispositions. If you are unsure how to characterize your crypto income, it is advisable to consult a top Canadian crypto tax lawyer for assistance.
Pro Tax Tip: Document All Speculative Crypto Transactions
Documenting all crypto transactions is of great importance in general. In the case of a pump-and-dump scheme, your documentation can serve as vital evidence that your transactions were legitimate and not part of fraudulent activities. You might be able to claim a capital loss, provided you have the documentation showing this loss occurred. At a minimum, the following information should be recorded for each crypto transaction:
- Date of acquisition and sale of the cryptocurrency.
- Type of crypto sold and what fiat currency/crypto was acquired in exchange for the sale.
- Adjusted cost base for each transaction.
- Sale price.
- Profits or losses on each transaction
FAQ
What if I was unaware that I was part of a pump-and-dump scheme in Canada?
If you can prove you were an unwitting participant, your tax treatment would likely remain the same as for any other crypto transaction, whether you incurred gains or losses. However, being involved in any scheme, even unknowingly, might attract scrutiny from the CRA. Maintain thorough records to support your tax position. Seek advice from an expert Canadian tax specialist if you are the subject of a CRA audit relating to a crypto pump and dump scheme.
How can I spot a crypto pump and dump?
- A sudden surge in trading volume with no apparent news or announcements.
- Promises of high returns or “insider tips” from unknown sources.
- A cryptocurrency’s price shoots up quickly with no fundamental reason behind the movement.
- Overhyped discussions or calls to buy a specific coin on platforms like Telegram, Discord, or Twitter. These promoters are generally paid to promote the coin by the insiders, or are given some presale tokens for their promotion efforts. These tokens will then be part of the dump in many cases.
While it’s possible to make a profit by buying before the price rises and selling before the dump happens, this is highly speculative and risky. Only a small number of people (usually those organizing the pump) will profit, while most investors who buy in at the peak are left with significant losses.
At the end of the day, you are the only one who is able to stop yourself from falling victim to a pump and dump. Before buying a newly launched crypto coin, it is important to do thorough research and only invest what you are willing to lose. These investments are highly risky, and when they are too good to be true, they usually are.
I invested in a crypto coin, and its value plummeted to zero. What is the Canadian income tax treatment?
To realize this loss for tax purposes, you would need to dispose of the token, possibly by selling it for whatever minimal value it retains or by trading it for another cryptocurrency. The capital loss can then be used to offset capital gains in the current year, with any unused portion of the loss able to be carried back three years or forward indefinitely to offset future capital gains.
However, if the crypto activity is considered business income rather than capital gains, the treatment could differ, potentially allowing for a full deduction against business income. Characterizing the loss on a business or capital account may require a legal analysis from a knowledgeable Canadian crypto tax lawyer, as it is a fact-based assessment and is not always straightforward.
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.
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