The Taxation Implications of Cryptocurrencies
In recent years, digital currencies, more commonly referred to as “cryptocurrencies,” have gained widespread popularity. These various currencies, including Bitcoin, Ethereum, and Litecoin can now be used as payments at businesses such as restaurants, retail stores, and real estate brokers.
What is a cryptocurrency?
A cryptocurrency is a form of digital currency that is not controlled by a central bank and is managed on a peer-to-peer network. Whereas traditional currencies are controlled by a central organization such as a central bank, with cryptocurrencies control is more laissez-faire, determined by the users themselves in how they use it daily.
Once a transaction is recorded by the network, it is kept in a digital ledger called the “blockchain,” which is a fixed, publicly-accessible record of every transaction. This confirmation normally occurs within a few minutes. Recording the transaction and adding it to the ledger is called “mining.” The people who perform these tasks are called miners, and they are compensated with cryptocurrency.
It is a widespread misconception that since there is no central authority controlling cryptocurrencies, transactions with them are not taxed.
The Canada Revenue Agency (CRA) has determined that for a unit of exchange to be considered a currency under tax law, it must be legal tender and controlled by a central authority. Since cryptocurrencies are not controlled by the central bank, they are not considered Canadian currency nor are they considered foreign currency by the CRA.
Instead, the CRA considers cryptocurrencies to be commodities. Under tax law, commodities are typically taxed upon disposition as capital gains. However, in cases where the cryptocurrency takes on the characteristics of a livelihood it can be, in some cases, taxed as income.
Whether the usage of cryptocurrency is taxed as income or capital gain depends on several factors set out by the CRA:
1. Frequency of transactions – Is the investor trading a few times a year or a few times a day?
2. Period of ownership – Is the investor holding the cryptocurrency for a few years or a few weeks?
3. Knowledge of securities markets – Is the investor knowledgeable and familiar with the cryptocurrency (or other securities) market or are they just dabbling?
4. Time spent – Does the investor spend hours a day on trading and keeping up to date with the market or just a few hours a month?
If the transaction is considered income, the taxpayer must record the proceeds of disposition of the cryptocurrency as business income and he or she is permitted to deduct eligible expenses against that income. If the transaction is considered capital, the taxpayer must report a capital gain or loss.
The CRA has imposed a high standard of record-keeping for cryptocurrencies, which may require the detailing of every transaction in a cryptocurrency, although the requirements and rules are evolving as the general usage of cryptocurrency changes.
The Canadian government is keen to address the fact that since digital currencies are not centrally regulated and are not legal currencies, they are prone to some risks that regulated currencies are not exposed to. Moreover, many of the insurance protections against deposits as imposed under the Bank Act do not apply. Cryptocurrencies are regulated under the Tax Act, as a commodity, and involve some special rules and restrictions.
Exchanging for goods and services
Where a unit of cryptocurrency is exchanged for a good or a service, the CRA considers the exchange to be a barter transaction. IT-490 “Barter Transactions” defines a barter transaction as a transaction between two persons where one commodity is exchanged for another commodity with no use of money.
From the vendor’s perspective, they have sold a good or service, so they must include the value of the good or the service in their income for the year, the same as if they had sold that good or service in the normal course of business. The GST/HST applies on these transactions and is calculated based on the fair value of the transaction, determined as the fair value as given up by the vendor.
From the purchaser’s perspective, they have disposed of a commodity and must pay tax on this disposal in the form of a capital gain, the same as if they sold an investment. A single Bitcoin is currently worth thousands of dollars, so the transaction would typically be a fractional unit.
If a taxpayer donates cryptocurrency units to a registered charity, the transaction is treated as an in-kind gift of capital property, discussed in IT-288R2 “Gifts of Capital Properties to a Charity and Others.” It is deemed a disposition equal to the fair value of the cryptocurrency donated. There are some variations on the valuation of the proceeds of disposition which a trained tax professional could discuss with a taxpayer.
The government of Canada expresses the following caveat:
• Transactions are not reversible
• Purchases and transactions made with digital currencies are not reversible.
• You can’t reverse the charges if you didn’t receive the product
• You can’t get your money back unless the seller agrees
• You might not be able to stop a payment
As digital currencies are also prone to fraud, discussing the CRA’s position regarding mistakes or fraud with a tax professional is prudent.
Digital currencies fluctuate as a market-traded activity and are not recognized as the equivalent of a national currency. However, many consumers are attracted to their usage and they are growing in popularity.
Cryptocurrencies can be used in place of a regular currency for some transactions and can even be extracted from special ATMs. They can also be traded as a commodity on a financial market, and their value can fluctuate, but rather than fluctuate while backed by a central currency such as the U.S. dollar, their value is determined by peer to peer sharing of usage.
As digital currencies operate in some instances as a replacement for currencies, the CRAs position may evolve as the nature of their usage changes. At this time, there is added scrutiny and requirements put on the users of cryptocurrencies which may become more or less stringent as the CRAs position on them changes. As a commodity is not typically used strictly as a unit of exchange in the same way as a cryptocurrency, legislation and case law may develop over providing exemptions or distinctions between their usage and the trading of traditional commodities such as oil and gas.
When involving oneself with cryptocurrencies, it helps to consult an attorney with tax experience such as Mark Feigenbaum. Mark is experienced in Canadian and cross-border tax disputes and is a trusted legal advisor to clients throughout the GTA. Mark can be reached at 905.695.1269.