III. Expectations and Limitations of Blockchain Analysis
1. What Is Blockchain Analysis?
In this section, we look at blockchain analysis as an investigative method that has proven useful in addressing tax enforcement challenges arising from the anonymity and decentralization of cryptocurrencies. By examining transaction data on the blockchain, it is possible to detect patterns, relationships, and activities among entities—such as identifiable individuals or organizations—involved in crypto transactions.
Transactions involving cryptocurrencies are recorded on the blockchain, and on public blockchains in particular, anyone can view and verify this information without special permission. This means that if a wallet address is known, it becomes possible to trace its transaction history and balances, as well as to infer which CEX accounts or wallets may be controlled by the same person. Blockchain analysis takes advantage not only of the traceability and transparency of cryptocurrencies, but also of their pseudonymous nature.
That said, blockchains themselves do not contain personally identifiable information. However, the process of converting fiat currency into cryptocurrency (known as an “on-ramp”) and converting it back into fiat (an “off-ramp”) is typically handled by centralized institutions that are subject to Know Your Customer (KYC) and anti-money laundering/counter-terrorist financing (AML/CTF) regulations.
As a result, these on- and off-ramps serve as key points of connection between on-chain activity and real-world identities. It should be noted, however, that decentralized exchanges (DEXs) generally do not offer services that directly convert cryptocurrencies into fiat currency.
Because centralized institutions still play a major role in providing crypto-related services, opportunities to receive payments in crypto remain limited compared to fiat currency, and real-world use cases for crypto as a means of payment are still relatively narrow. This situation persists in part because most cryptocurrencies are primarily used for purposes other than everyday payments.
For example, suppose that (1) an unverified CEX account or wallet address—one that has not completed identity verification—has conducted transactions on the blockchain with (2) a domestic CEX or another exchange that does require identity verification.
If it can be determined that both (1) and (2) are controlled by the same individual, then the identity of the person behind (1) can also be established. From there, other CEX accounts or wallets likely managed by the same person can be identified as well.
The National Tax Agency can identify (ⅰ) domestic CEX accounts by requesting information on Japanese taxpayers who meet specified criteria from domestic centralized exchanges (CEXs) during the investigation selection phase, as well as by requesting information on investigation targets from domestic CEXs during individual audits. Once it is established that a specific account is transacting with (ⅱ) “overseas CEXs or private wallets,” blockchain analysis can identify indicators that (ⅰ) and (ⅱ) are managed by the same individual. Through this process, it becomes possible to identify the individual controlling (ⅱ) and to uncover additional overseas CEX accounts or wallets that are likely under that individual’s control. Accordingly, blockchain analysis is a highly effective investigative tool in both the case selection stage and the individual audit stage.
Blockchain analysis can remain effective even where technologies designed to enhance anonymity are deliberately employed. For example, blockchain data may still allow investigators to trace transactions and fund flows or to identify the controllers of CEX accounts and private wallets in situations such as the following1:
・Transfers of crypto assets from Wallet A to Wallet B using multiple intermediary private wallets to complicate tracing
・Use of mixing or tumbling services that pool crypto assets from multiple users to obscure the origin and ownership of funds
・Use of services or protocols that enable transfers between different blockchain networks, resulting in complex and layered transaction paths
・Use of privacy-focused cryptocurrencies, such as Monero or Zcash, which employ advanced cryptographic techniques to conceal transaction details
At present, tax authorities are likely to depend primarily on blockchain analysis tools provided by private-sector firms. Although basic analysis can be conducted using publicly available (free) tools and websites, more precise and reliable analysis is achievable through professional platforms such as Reactor, a transaction-tracking tool offered by Chainalysis, a leading blockchain analytics company. By inputting a specific wallet address into Reactor, analysts can identify address groups associated with that address through clustering techniques—groupings of multiple wallet addresses inferred to be controlled by the same entity. This allows investigators to determine which entities (such as individuals, organizations, CEXs, or other groups) are connected to those addresses, or to visualize transaction flows graphically to identify the routes and ultimate destinations of funds.
Specifically, Reactor enables the following analytical functions2:
・Wallet address association (clustering)
・Analysis of cluster attributes, including addresses contained within the cluster, aggregate balances, internal and external transaction flows, and the cluster’s classification (e.g., CEXs, organizations involved in fraud or money laundering)
・Linkage between clusters and identified entities, such as determining that a particular wallet address belongs to an overseas exchange; the use of Chainalysis’s proprietary entity attribution data enhances both the accuracy and efficiency of this process
In addition, Reactor provides intuitive visualizations of transaction flows and inter-cluster relationships, allowing analysts to understand how funds move across the blockchain ecosystem. This visualization capability is particularly effective in identifying the ultimate destination or storage location of crypto assets.
According to the indictment and related court documents in the case in which Roger Ver, nicknamed “Bitcoin Jesus,” was charged with offenses including evasion of the U.S. exit tax and filing a false tax return, the IRS identified Bitcoin addresses associated with Ver and his companies and tracked his holdings through cluster analysis.
It is alleged that Ver concealed the exact amount of Bitcoin he held from his law firm and appraisers by providing false or misleading information.
However, IRS investigators identified a cluster of four primary Bitcoin addresses associated with him by combining cluster analysis with other investigative evidence.
As a result, the IRS determined that as of February 3, 2014, Ver held approximately 130,000 Bitcoin, either directly or through entities under his control3.
In another U.S. case, an early Bitcoin investor received a two-year prison sentence for tax evasion involving the underreporting or failure to report more than $1 million in profits from crypto-asset transactions. The taxpayer attempted to conceal the gains by inflating acquisition costs, using multiple wallets, conducting face-to-face transactions, and employing mixers. The case is notable as the first criminal prosecution for tax evasion based solely on crypto asset transactions.
In that case as well, Chainalysis’s Reactor tool was used to trace the flow of funds. The taxpayer transferred Bitcoin through multiple wallets, conducted face-to-face peer-to-peer transactions, and used mixers in an attempt to obscure the transaction trail. Nevertheless, IRS investigators were able to leverage Chainalysis’s tools and data to track the movement of funds from acquisition to disposal, identifying key details such as transaction dates, valuation amounts, and counterparties4.
2. Large-Scale Screening Using Blockchain Analysis
By maximizing the use of the vast amount of information publicly available on the blockchain, it may be possible to support large-scale investigative screening.
This approach begins with information recorded directly on the blockchain, rather than with data obtained from domestic centralized exchanges (CEXs). For example, it may be possible to identify and list overseas CEX accounts or wallet addresses that have previously transacted with domestic CEX accounts. Such a list could then be used as a basis for investigative screening.
However, the listed accounts or wallet addresses are not necessarily controlled by users of the relevant domestic CEX.
Moreover, indiscriminately treating all domestic CEX accounts that have even a single transaction with overseas CEXs or private wallets as high-compliance-risk cases would be inefficient.
From an efficiency standpoint, it is therefore necessary to identify and filter domestic CEX accounts with a higher risk of tax noncompliance.
In this context, Chainalysis’s Data Solutions, a tool designed to aggregate and filter blockchain data, may play an important role. Data Solutions systematically searches and aggregates blockchain data, identifying transactions and addresses that meet specified criteria aligned with investigative objectives. This enables investigators to narrow the scope of cases requiring more detailed examination.
For example, at the stage of investigation selection, Data Solutions can filter wallet addresses obtained from decentralized exchanges (DEXs) according to specified conditions.
This process extracts addresses with a higher risk of tax noncompliance, thereby narrowing down the wallets that should be prioritized for further investigation.
Once this initial screening is complete, Reactor can trace and analyze blockchain transactions associated with these selected wallets. Through this process, it may become possible to identify individuals who could be Japanese taxpayers.
Furthermore, tax investigations relating to crypto assets continue to accumulate, and tax authorities continue to gain investigative experience. As a result, it may become possible to identify and categorize patterns indicative of fraudulent transactions or underreporting.
In addition to the use of artificial intelligence, the sharing of insights and data among tax authorities across jurisdictions may also prove beneficial.
According to the author’s interviews with Chainalysis Japan, Inc., these tools could enable, for example:
- the identification of abnormal transaction patterns on the blockchain suggesting improper tax treatment, starting from domestic CEX accounts; and
- the development of systems that trigger alerts when crypto assets with large unrealized gains accumulated in private wallets are transferred elsewhere.
3. Expectations for Blockchain Analysis and Its Limitations
As described above, blockchain analysis can serve as an effective tool when tax authorities face enforcement challenges during tax audits or the selection of audit targets. These challenges stem from the anonymity and decentralization of crypto assets. The technique seeks to overcome them by analyzing publicly available address and transaction data on the blockchain. It then links this data to information from CEXs and other entities that have verified user identities.
However, regardless of whether the analysis links to domestic or overseas CEXs, it is essential that identity verification has been conducted at those CEXs. The same constraint applies as with requests for reports from specific businesses that rely on information from CEXs conducting identity verification, or with the CARF system. Even with full use of blockchain analysis, tax authorities cannot completely overcome the enforcement problems caused by the anonymity and decentralization of crypto assets.
In short, blockchain analysis alone does not reveal the identity of holders of accounts on CEXs that do not conduct identity verification, or of private wallet holders. Therefore, if a taxpayer uses such an account—or a private wallet unconnected to a CEX that conducts identity verification—it is impossible to identify the holder. In this sense, blockchain analysis has its limitations.
This indicates that, at least at present, it is extremely important for CEXs and similar entities to implement identity verification procedures. It is equally important for taxpayers to use such entities to ensure proper tax enforcement regarding crypto assets. However, through blockchain analysis, identification may still be possible in certain cases. If (1) an “account or wallet address on a CEX that does not perform KYC” has ever conducted a transaction with (2) a “domestic CEX or other CEX that performs KYC,” it may be possible to identify the person managing (1).
Furthermore, it is possible to identify the transactions and balances of crypto assets associated with that address, as well as CEX accounts or wallets managed by the same individual. Such clustering leads to an increase in opportunities for identifying individuals as described above.
Moreover, transactions on DEXs are recorded on the blockchain. As a result, it is possible to determine when and what types of transactions a specific wallet address conducts on a DEX, as well as the scale of those transactions.
Blockchain analysis of the kind described above can serve as a powerful tool for tax authorities during tax audits. Therefore, in Japan as well, the NTA must actively and effectively utilize high-performance blockchain analysis tools. This is essential to address the tax enforcement issues caused by the anonymity and decentralization of crypto assets. To that end, the NTA must also strengthen the training of tax investigators.
- https://www.chainalysis.com/blog/crypto-money-laundering-japan-japanese/ ↩︎
- https://anchor-u.com/product/chainalysis/.United States v. Sterlingov, 719 F. Supp. 3d 65, 71-77 (D.D.C. 2024). ↩︎
- See United States v. Roger Keith Ver , No. 2:24-cr-00103-MWF (C.D. Cal. indictment filed Feb. 15, 2024), https://storage.courtlistener.com/recap/gov.uscourts.cacd.915322/gov.uscourts.cacd.915322.1.0.pdf; U.S. Attorney’s Office, C.D. Cal., Early Bitcoin Investor Known as ‘Bitcoin Jesus’ Indicted for Allegedly Committing Tax Fraud and Causing $48 Million Loss to IRS (Apr. 30, 2024), https://www.justice.gov/usao-cdca/pr/early-bitcoin-investor-known-bitcoin-jesus-indicted-allegedly-committing-tax-fraud-and. ↩︎
- See U.S. Dep’t Of Justice, Early Bitcoin Investor Sentenced for Filing Tax Returns that Falsely Reported His Cryptocurrency Gains (Dec. 27, 2024), https://www.justice.gov/opa/pr/early-bitcoin-investor-sentenced-filing-tax-returns-falsely-reported-his-cryptocurrency. ↩︎
