A Canadian Tax Guide For Cryptocurrencies
Before we can get into how cryptocurrencies are taxed in Canada, we have to understand a bit about what cryptocurrencies are, how they are created, and how they can be used. This guide will start by providing an overview of what cryptocurrencies are, how they are created and used, and finally, how they are taxed in Canada.
What are Cryptocurrencies?
Speaking formally, a cryptocurrency is a system that meets six specific conditions. These conditions include the use of a distributed consensus rather than a central authority, the need to have an overview of the currency and its ownership, controls over how new units can be created and how to determine ownership of the newly created units, that ownership can only be proven cryptographically, that transactions can be performed and ownership of the units transferred, and a failsafe that only allows one change of ownership of the same unit over conflicting attempts of exchange. This is highly technical, so let us consider a more layman’s definition.
Cryptocurrencies are essentially digital assets that are designed to work as a medium of exchange, like money. They are digital items that, for one reason or another, are assigned value. Unlike money issued by a government, there is little economic activity or tangible backing up the value of a cryptocurrency. The reason they are called “crypto” is that strong cryptography – or in other words, a strong computer code – is used to make the transaction secure. Not only is cryptography used to make transactions secure, but the same cryptography is used to control the “creation” or “mining” or new digital coins as well as to verify the transfer of ownership of new and existing coins.
Cryptocurrencies, though mediums of exchange like money, are not money. They don’t have a physical expression in the world, and, unlike money, they are not issued by a central authority or government. This doesn’t mean that cryptocurrencies are not, in some cases, centralized. If a currency has a centralized crypto exchange, then it is considered a centralized cryptocurrency. Because they are decentralized in production and monitoring, the entire cryptocurrency system, as a collective, produces new units at a set rate and monitors the system. No one person is in control. This set production rate is defined when the particular cryptocurrency system is created, and the rate is public knowledge. Most of the systems are limited in that they are designed to reduce the production of new units over time until some upper limit is reached.
How do you know that what you have in your digital wallet is a real unit of a cryptocurrency? A blockchain is what provides for a cryptocurrency’s validity. But what is a blockchain? A continuously growing list of records, or blocks, that are linked together and made secure using cryptography is what is called a “blockchain”. Usually, each block, or records, contains a timestamp, transaction data, and a point to the previous block. This design makes blockchains highly resistant to modification, making the data that is recorded trustworthy, verifiable, and permanent. Copies of these blocks are maintained and verified by the community using a peer-to-peer network that follows pre-set protocols for validating the blocks. In technical terms, blockchains are an example of a distributed computing system that is public, and it is this decentralized and public nature of the system that ensures the integrity of the entire system.
How are Cryptocurrencies created?
In this part, we are not as concerned with the system of a cryptocurrency that gives rise to it, but to how new units of a particular cryptocurrency are created and put into circulation.
New units of a cryptocurrency are crated through a process called “mining”. In any cryptocurrency network, you need computing power to validate transactions and to contribute to the peer-to-peer network that is the backbone of the cryptocurrency. This takes a tremendous amount of computing power and energy. In order to reward people for the use of their computing power, the investment in computers, and the power it takes to validate transactions – which is called mining – the miners are rewarded with new units of the cryptocurrency.
Once created, or purchased, or received from others, you have to have somewhere to store your cryptocurrency. Wallets, or crypto wallets, are where you can store your cryptocurrency units. They are stored with two keys – a public key and a private key. These keys, also known as addresses, are how you and others can receive, use, or send the units of the cryptocurrency. Using the private key, you or the owner of the wallet can write in the public ledger, with the effect that the specific cryptocurrency is spent or sent. With the public key, it is possible for others to send cryptocurrency to your wallet.
How are Cryptocurrencies Taxed in Canada?
Now that we have a rudimentary understanding of what cryptocurrencies are and how they are created, we can talk about how they are taxed in Canada. To see how they are taxed, we should consider the ways that you can get a hold of a unit of a particular cryptocurrency. So, how can you get a cryptocurrency? We know you can get it by (1) mining it, (2) having someone else mine it for you for a fee, (3) by purchasing it from someone else (like an online exchange) or selling it to someone else for Canadian currency, (4) by receiving it in exchange for goods and services you provide, or (5) by receiving it as a gift. Another layer is what this unit of bitcoin is – is it an investment and as such capital property or is it an inventory item.
Canada has a well-established way of taxing various categories of income or profits, and we just need to figure out how these ways of getting cryptocurrency and the character of the unit of cryptocurrency line up with the taxation methods. Ignoring employment income, the three categories of income or gain, we have to worry about (A) business income, (B) property income, and (C) capital gains or losses. Before we get into the taxation of cryptocurrency specifically, let us consider how these three categories of increasing value are taxed in Canada generally.
First, we will look at business versus property sources of income. Although they are treated the same mostly, and the “profit” from each of these sources is what it taxes, not the revenue, there are some important differences. The details of the differences are well beyond the scope of this article, but they can be very important in specific circumstances.
The difference between a business source and a property source of income is not based on some clear-cut difference, but it comes from the consideration of various factors that consider the level of activity or effort involved in the creation of that particular income. Canadian courts consider a business to be “anything which occupies the time and attention and labour of a man for the purpose of profit” and often is something that takes an organized effort. Property, on the other hand, is any kind of interest or right that a person can have in something else. As a result, property sources of income are those where you gain income from the mere possession of property, which is often considered to require much less effort and organization than a business would. Next, we will consider the difference between capital gains and other gains/income. A capital gain or loss comes from the disposition of a capital property and the difference between your cost in the property and the proceeds on disposition. So the key factor to consider is whether the property, in this case, the cryptocurrency, is a capital property or some other property (like inventory). The difference between capital and non-capital properties is also not clear-cut. The general distinction is that a capital property is the source of income – like a tree is the source of fruit – while non-capital properties are what you dispose of to gain income – like the fruit you sell as part of your farming business. These differences are far from clear and are some of the most litigated issues in tax court.
Let us get back to Cryptocurrencies specifically and how they are taxed. The obvious answer is that if you get the currency as part of business activity, then its business income and taxed as business income. If you get the cryptocurrency as part of gaining or producing income from property, then its property income and taxed as such. And if the cryptocurrency is capital property to you, then your disposition of it gives rise to either a capital gain or a capital loss. If what you have is a business or property profit or loss, then the profit is fully included in your income, and the loss is deductible fully in the year or can be carried back three years or forward twenty years. If you have a capital gain or loss, then you include half the gain in income or deduct half the loss against capital gains that year, or you can carry back the loss for three years or forward indefinitely (but you can only set it off against capital gains and not other income). There is, therefore, the motivation to characterize increases in value as capital gains, so you only pay tax on half the amount, and characterize losses as business or property losses do you can deduct the entire loss against any source of income. Unfortunately, unlike at Dairy Queen, you can’t have your cake and eat it too.
The Canada Revenue Agency (CRA) treats cryptocurrencies like a commodity for taxation purposes in most cases. This means that the CRA generally treats any income or gain from any transaction, including gifts, involving cryptocurrencies as either business income or as a capital gain. In deciding which approach to take, the CRA will consider the surrounding facts and circumstances and refer to the general tax principles we discussed earlier in the article. The CRA gives this reciprocal treatment, meaning that if your gains or profits are taxed as business income or capital gains, then your losses will get the identical categorization in the same circumstances.
Let us consider each of the earlier common ways of getting or getting rid of cryptocurrency. As a reminder, they are: (1) mining it, (2) having someone else mine it for you for a fee, (3) by purchasing it from someone else (like an online exchange) or selling it to someone else for Canadian currency, (4) by receiving it in exchange for goods and services you provide (or, on the other hand, handing it over as payment for goods or services you purchased), or (5) by receiving it as a gif (or you can give the crypto as a gift).
(1) Where you mine cryptocurrencies, then what you get when you receive the cryptocurrency you mined is an inventory item. The disposition of the inventory item, then, results in income from business, and your profits, if there are any, are taxed as business profits.
(2) Where you have someone else mine cryptocurrencies for you for a fee, then the person providing you with the service has income, and you have income when you get the resulting cryptocurrency. The person doing the mining may just be leasing you computer ‘space’, in which case they have income from property, or they may be doing all the mining activities for you, meaning that they have income from a business. You, the person who has commissioned the mining, will be in the same position as if you had hired others or outsourced the work of mining, and you will still have income from a business.
(3) Where you purchase the cryptocurrency from someone else, you have not undertaken any activity that is taxable. It would be the same thing as purchasing a business or a rental property, but not doing anything with it yet. However, where you sell that cryptocurrency to someone else, then your income or gain are taxable depending on the character of the cryptocurrency in your hands. If the currency is capital property to you, then the gain is a capital gain, and the loss is a capital loss. If the currency is not capital property to you, then the gain is business income, and the loss is a business loss.
(4) Where you receive a cryptocurrency in payment for or in exchange for goods or services you provide, then the first question is whether the provision of the goods and services are a source of income for you. Whether or not the provision of goods and services is a source of income is complex, and we are going to assume for purposes of this article that they are part of your business activities. This means that the cryptocurrency would be your payment for the goods and services you provide, and the value of the goods and services provided is going to be considered revenue to you as a payment of cash would.
The CRA treats use of cryptocurrency as a barter transaction and applies the barter transaction rules. There are two ways for you to determine the value of the cryptocurrency you receive and, therefore, your revenue from the trade. The fist is to use the value of that currency on an exchange if that currency has an exchange. The other is to use the usual fair market value of the goods and services you have provided – what you would have charged if you would have charged cash – as the value of the currency you have received. Whatever method you chose, make sure it is consistent and reasonable. Despite this, know that the CRA takes the highest fair market value of the two items exchanged to be the value to apply to the transaction, and it is up to you to show that you have a reasonable, consistent method of valuation that you have used so as to avoid the CRA coming in and putting a different value on your transactions.
Another important note is that where you are providing goods and services for cryptocurrency, and you meet the threshold for having to charge GST/HST on the value of the transaction, then you have to charge the GST/HST on the barter transaction as well. You can not avoid GST/HST by using a cryptocurrency.
Not only are there tax consequences for the person who is providing the goods and services, but there are going to be tax consequences for the person using the cryptocurrency to make the purchase. This is because the value of most cryptocurrencies is not stable, but rather fluctuates up and down daily. Where you purchased a unit of a cryptocurrency at $100 and then used that unit to make a purchase, no matter what the cost of the purchase is when you dispose of the currency you have either a capital gain or loss (in most cases) depending on the then-current value of that unit. For example, if the value was $110 when you used the unit of cryptocurrency, then you have a capital gain of $10 that you have to report and pay tax on.
(5) Where you receive cryptocurrency as a gift, then you are treated the same way as having received anything else of value as a gift. The value of the gift, if not taxable to you, as the recipient. However, the person giving the gift may have tax consequences where the gift is to a person who is not at arm’s length to the giver. Therefore, in some cases, the person giving the gift may have a capital gain or loss on the gifting of the cryptocurrency. The same principles as the payment for goods and services in a barter transaction apply. Where you bought the cryptocurrency at $100 but gave it as a gift to someone you don’t deal with at arm’s length at a time where the unit was worth $110, then you have a capital gain of $10 to report and pay tax on.
The above five are just some of the circumstances that involve cryptocurrencies and lead to tax consequences. Other circumstances include that you can exchange one cryptocurrency for another (to which the barter rules apply), or you can receive cryptocurrencies as an inheritance. As with anything tax-related, its best to get an expert on your side so that you can be sure you are meeting your self-reporting and self-assessing obligations under the Income Tax Act.
Common Types of Cryptocurrencies
There are currently over 1,800 cryptocurrency specifications in existence. The most common cryptocurrencies in use are Bitcoin, Ethereum, Ripple, Litecoin, and Bitcoin cash. No matter what type of cryptocurrency you use, the same rules will apply when it comes to how transactions or exchanges using them are taxed.